Initial Preparation for a Mortgage

Table of Contents

1. Review Your Personal Financial Situation

Lenders look at your overall financial situation, not just one factor like your credit score, to decide if you’re a good borrower. They consider four main things:

Income: The money you earn every month from all sources, including your job, investments, and any alimony. Lenders want to see that you make enough to pay your mortgage and other expenses.
Debts: Any money you owe, like credit card bills, car loans, personal loans, and mortgages. Lenders are concerned if your debt-to-income ratio exceeds 0.40 (explained below).
Assets: Things of value you own, like homes, cars, land, stocks, and bonds. If your debt-to-income ratio is high, lenders might still feel comfortable lending to you if you have valuable assets, especially liquid assets (like stocks or bonds) that can easily be turned into cash.
Expenses: The bills you pay every month, such as utilities, homeowner’s association fees, alimony, and costs for things like medical care, transportation, and entertainment. If your income doesn’t cover these costs, lenders will likely deny your loan unless you have a lot of liquid assets.

How to Create a Monthly Budget Worksheet

A monthly budget worksheet lists your income and expenses for the month. Creating one will help you:
See how much money you have left each month to pay your mortgage and other bills after buying a home.

Gather the documents and information you need to understand your financial situation.
Once your budget is set, you can spot areas where lenders might have concerns about your finances and try to fix them before applying for a mortgage. For example, if your expenses are slightly higher than your income, you can improve your chances with a lender by cutting back on unnecessary spending. While you may be able to make these changes quickly, you’ll need to maintain them for 2-3 years, as most lenders want to see your financial history to feel confident approving your loan.

How to Calculate Your Debt-to-Income Ratio

Your debt-to-income ratio helps lenders see how your monthly debts compare to your monthly income. To figure it out, divide your monthly debt by your monthly income. Before applying for a mortgage, your debt-to-income ratio should be below 0.40 and ideally around 0.35 or less. For example, if you have $1,000 in monthly debt and $5,000 in monthly income, your ratio would be 1,000 ÷ 5,000, which equals 0.20.

2. Determine How Much You Can Afford

Unless you have a history of bankruptcy or bad credit, lenders will likely approve you for a mortgage where the monthly payment is up to one-third of your monthly income before taxes. If your income before taxes is $6,000, you could be approved for a mortgage with a monthly payment of up to $2,000.

Should You Get the Biggest Mortgage You Can?

No, just because you can get approved for a specific-size mortgage doesn’t mean you can afford it. To determine if you can afford a mortgage, you need to consider more than just your current financial situation. Consider your future job prospects, plans for children or ageing parents, and home repair costs. These factors affect how much risk you can handle and will help you decide if you should go for a riskier mortgage, like an adjustable-rate mortgage (ARM), or stick with a safer, more predictable one, like a 30-year fixed-rate mortgage.

How to Determine How Much You Can Afford

Don’t rely on a lender to tell you how much mortgage you can afford. Instead, figure it out yourself based on your financial situation. One way to do this is to subtract your total monthly expenses (including debts) from your monthly income. The remaining amount should cover your expected mortgage payment, with some extra left over. For example, if you have $1,000 left after paying all your expenses, you should feel comfortable getting a mortgage with a monthly payment of $500–700

The 200-Times-Your-Rent Rule

If you currently rent, this rule can help you estimate what size mortgage you can afford:
Most homebuyers can afford a mortgage that is 200 times their monthly rent. For example, if you pay $800 a month in rent, you might be able to afford a mortgage of $160,000 (200 × $800)

3. Review Your Credit Report and Score

Your credit history shows how you’ve used and managed credit. It includes nearly every financial transaction involving credit from the past 7–15 years. Lenders look at your credit report and credit score, along with your income, debt, assets, and expenses, to decide whether to approve you for a mortgage and what interest rate to offer.
Credit report: A credit report is a document that lists your current and past credit accounts, including any significant events like bankruptcy or tax liens. It gives lenders an idea of your credit history, including your credit accounts, your credit limits, and how well you’ve paid them off.
Credit score: A credit score is a number, based on your credit history, that shows how trustworthy you are with credit. Scores range from 300 to 850, with 850 being perfect credit. Lenders usually offer the lowest interest rates to borrowers with scores over 700.

Do credit scores really matter?

Lenders consider your credit score when deciding whether to approve your mortgage and what interest rate to offer. For example, if you have a credit score of 750, you might get a 6% interest rate loan. If your score is 550, the rate might be 9%. While 3% might not seem like a lot, on a $100,000 mortgage, that difference could cost you $2,400 per year or $74,000 over the life of a 30-year loan. If your credit score is very low (below 600), improving it before applying for a mortgage is a good idea. You can learn more about fixing your credit in the “Improving Your Credit” guide.

How to Order Your Credit Report and Credit Score

Before applying for a mortgage, you must check your credit report and get your credit score, which is not always included in the report. You can get a free copy of your credit report at www.annualcreditreport.com. If you want to see your credit score, you can pay a small fee on that website.

How to Review Your Credit Report

The main reason to review your credit report is to ensure accuracy. If you find mistakes, like accounts you didn’t open or bills that show as unpaid even though you’ve paid them, you need to fix them before applying for a loan. Contact one of the three credit reporting agencies below to correct an error. They must respond to your request within 30 days.
Equifax: 800.685.1111; www.equifax.com
Experian: 888.397.3742; www.experian.com
TransUnion: 800.888.4213; www.transunion.com

4. Assemble Information for Lenders

To speed up the mortgage application process, have the following documents and information ready:
Your current home address and two previous addresses
If you rent, the names and addresses of your current and past landlords
The names and addresses of your current and previous employers
W-2 or 1099 forms and tax returns from the past two years
If you’re not self-employed, two recent pay stubs and contact information for your employer’s HR department
Checking and savings account numbers, plus the contact details for your bank
Bank and investment account statements from the last 2-3 months
Account details and statements for significant assets you own, like the title to your car(s)
If someone (like a friend or family member) is helping with your down payment, a signed gift letter from them
Written explanations for late payments or any credit problems, such as past legal judgments, liens, foreclosures, or bankruptcies

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