What does a potential homebuyer need to do before attempting to secure a real estate loan?
The first step in buying your dream home is applying for a real estate loan. This type of loan, which is also referred to as a mortgage, is commonly used by homebuyers to finance real estate. When approved, borrowers sign a legal document (known as a mortgage note) that promises to repay the loan, with interest and other costs over a period of time. A real estate loan is generally one of the least expensive ways to finance a home, but it can also be one of the more intimidating processes a beginner homebuyer undertakes.
When seeking a real estate loan, it’s critical for homebuyers to understand the importance of preparation. The process of applying (and being approved) for a mortgage loan can be both time-consuming and complex, as it requires an immense amount of time, paperwork and patience to complete. However, there are a few preliminary tasks homebuyers can do to make the process smoother.
Real Estate Loan Checklist: 10 Things To Complete
Because the road to homeownership starts with a real estate loan, here are 10 things potential homebuyers should do before applying:
1. Check Your Credit
The first step to obtaining a real estate loan begins with checking your credit. The process includes pulling your credit report to evaluate where your credit score stands, as this three-digit number is a necessary ingredient to borrow money.
“Credit scores are a crucial component of the homebuying process, impacting everything from the size of a mortgage payment to the interest rate on a home loan,” said Senior Vice President for TransUnion, Ken Chaplin. “People with subprime credit may face financial barriers to homeownership, making it difficult for their dream home to become a reality.”
There are several credit scoring models that have their own evaluation system. FICO, the most common scoring model, will analyze a credit score in points, with credit scores ranging from 300 – 850: bad credit (300 – 600), poor credit (600 – 649), fair credit (650 – 699), good credit (700 -749), excellent credit (750 – 850). The calculation of a credit score will typically consist of five major factors:
- Payment History = 35 percent
- Outstanding Balances = 30 percent
- Length of Credit History = 15 percent
- Types of Accounts = 10 percent
- Credit Inquiries = 10 percent
A low credit score won’t automatically disqualify you from a home loan or real estate deal, but it will affect several key factors of your loan, including the size, the mortgage rate and access to certain loan programs. A quality credit score is an indispensable asset for homebuyers and one they continuously work to improve.
2. Perform A Credit Audit
Once you’ve pulled your credit report and confirmed your credit score, it’s now time to perform a credit examination. This process is the equivalent to taking a highlighter to your credit report to outline what you did right, where you went wrong, and how you can improve. This is commonly carried out in the beginning stages of applying for a home loan, as it can sometimes take weeks, months, and even years to make the necessary adjustments.
3. Dispute Inaccuracies, Late Charges & Negative Information
Now comes the time to fight inaccuracies on your credit report. Because negative information can adversely affect your chances of securing a real estate loan, it’s critical that homebuyers not only review their credit report, but examine and verify everything is correct.
Homebuyers seeking to dispute inaccuracies are recommended to contact both the credit bureau and company that provided the information to the bureau. Under the Fair Credit Reporting Act, these two entities are responsible for rectifying inaccurate or incomplete information on your credit report. In most cases, this can be completed in two steps:
Step One: Contact the credit bureau and inform them of the information you believe to be incorrect. Along with providing your complete name and address, this should include identifying each item in your credit report you dispute, explanation of why you dispute the information, and a request for correction. This should also include copies of any related information to your dispute.
Step Two: Contact the appropriate creditors and explain you are disputing the information they provided the bureau. This also includes sending copies of documents that support your position.
4. Pay Off Debt
Another element to obtaining a real estate loan is debt-to-income. Lenders will compare how much you make versus how much you spend, to determine how much you can reasonably afford. In most cases, lenders will not approve a homebuyer if their debt is more than 36 percent of their income, with some lenders requiring more stringent debt-to-income ratios. The are generally two types of debt-to-income ratios that lenders look for:
Front-End Ratio: This relates to housing costs, including the percentage of income that goes towards the expense.
Back-End Ratio: This ratio reveals how much a potential homebuyer’s income goes to debts, such as credit card bills, car payment, child support, student loans and other debt.
When preparing to apply for a real estate loan, the best thing a homebuyer can do is reduce the amount of money they owe. Reducing the balances on credit cards or other financial obligations will help to lower the percentage of your income that goes towards paying monthly debt. In essence, this will help to free up credit, including the amount of money you can borrow.
5. Determine What You Can Afford
A common mistake homebuyers make in the beginning stages is looking for the home they desire, rather then what they can comfortably afford. While lenders will have lending guidelines in place to determine the amount of money you can borrow, it’s also important that buying a house makes financial sense for you and your family. That said, it’s imperative that potential homebuyers consider both their current (and future) finances when getting started. In some cases, renting may be a better option compared to buying, so it’s important to compare the costs of renting vs buying to gain a better understanding of where you stand.
6. Gather Work History
Employment history is another important factor to obtaining a real estate loan. Generally speaking, lenders will want homebuyers to have at least two years’ history with a company, but it’s not an absolute. Lenders will take into account several factors, including if you were in school, military service, or switching career fields.
The purpose of gathering work history is to verify you have a reliable source of money coming. Lenders are essentially determining your risk level, including whether or not you have the ability to make your monthly payments.
7. Assemble Income Information
Similar to work history, another component to securing a real estate loan is verifying your income. Homebuyers should assemble their income information, including pay stubs, tax returns, bank statements, brokerage statements, work contract and other documentation to verify their source of income. This step is crucial to not only determining how much you can afford, but confirming that you can make your monthly payments.
8. Down Payment
The next step in applying for a real estate loan is the down payment. The amount a homebuyer pays — somewhere between three percent and 20 percent of the home’s price — will depend on a combination of factors, including credit and financing. Loan-to-value ratio (LTV) is another aspect that lenders look at. This ratio, which compares the value of the home with the value of the loan, is used by lenders to assess the amount of exposed risk they’re taking on with the mortgage. For example, a low LTV ratio would create higher mortgage payments each month, as you have less equity ownership in your home.
Aside from the down payment, homebuyers will also need extra funds to pay for closing costs and other obligations in the home buying process. Additionally, it’s important that potential homebuyers avoid opening up any new lines of credit during this process, as it can affect your chances of being approved.
9. Compare Lenders
The second-to-final step in securing a real estate loan comes down to simply comparing your options. Whether that entails researching lenders or asking friends and family, it’s important you take the time to examine your choices, as each lender will handle different types of loans. Remember, not all lenders offer the same loans, so it’s important for homeowners to conduct their due diligence when buying a home, especially when finding a lender.
10. Get Pre-approved, Not Pre-Qualified
The last step to obtaining a real estate loan is getting pre-approved. This process differs from getting pre-qualified, as the latter compares loan details without having your credit access, while the former means lenders have run your credit and reviewed your finances. It’s important potential homebuyers understand the difference between pre-approval and pre-qualified, as this could ultimately affect your chances of buying your dream home.
The road to securing a real estate loan is no easy task. That said, arming yourself with the necessary information and knowledge, as well as preparing your documentations in advance, will help assist potential homebuyers in homeownership.