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Down Payment or Debt?

Is it more important to have no debt or a large down payment when applying for a mortgage?

My wife and I are going to try qualifying for a home loan soon. Would it be better to pay a $9,000 balance on a timeshare mortgage we have, and not touch the $15,000 we have in savings? Or would it be better to use our savings to eliminate all our debts?

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Highlights

  • Mortgage lender want four qualities in an ideal borrower.
  • You must demonstrate 2 years of employment history.
  • Your debt-to-income ratio is important.

You may be looking at qualifying for a mortgage a bit too simplistically. A mortgage lender will not only look at your debt or the amount available for a down payment. A mortgage lender looks at both of those, as well as two other variables:

  1. Steady, two-year income history
  2. Relatively clean recent credit history
  3. A debt-to-income ratio of 36% or less
  4. A down payment

The perfect applicant has all four of the above qualities. Before we look at each of these, let's discuss what a mortgage is and why lenders want these four qualities.

Mortgage in Brief

A mortgage is a legal document that sets forth the conditions of the loan, lays out the manner and duration of repayment, and pledges the borrower’s property (home) as security for the loan. The mortgage principal, the amount of the loan required to buy your home, and interest, the fee charged for borrowing the money, will typically be large enough to require mortgage payments for a significant period of time — often 15 to 30 years.

To help determine the amount you may be eligible to borrow for a mortgage loan, consider getting pre-qualified with a mortgage lender. This free service generally takes about two days and involves providing income, asset and debt information to a lender who may issue a letter to the home shopper.

Taking this process a step further, a potential home buyer may get pre-approved for a mortgage. This means getting a guaranteed loan for a certain amount that generally lasts for 60 to 90 days from the date issued. A pre-approved loan may involve a nonrefundable fee, but is often considered an advantage for a buyer because it speeds up the closing process.

Ask the lender about the following items: the types of loans available to you and whether there are any qualifying guidelines, the level of the minimum down payment, and what is included in the monthly mortgage payment — typically, the payment will include principal and interest of the loan, property taxes, and homeowner’s insurance, or PITI. Your payment may also include and any homeowner’s association dues, if applicable.

Employment History

Your employment history is also considered when applying for a loan. Have all paperwork connected to your current and prior employment on hand for the application. Collect any W-2 or 1099 forms from the last 2 to 3 years. Your employment history is looked at during the application and scrutinized based on income and any recent shifts in employment status. Any sudden or unexplained job changes within approximately six months of applying for the loan will be scrutinized.

Lenders look for a stable employment history. If you've been jumping from job to job within a six month period, it shows unstable or erratic income possibilities. As a rule of thumb, stay with one job for at least six months to a year prior to applying for a loan. Income changes look especially suspicious. If you experience a sudden dramatic increase or decrease in income, be prepared to provide a full verbal or written explanation along with your paperwork.

Credit History

A credit report gives potential creditors a snapshot of your credit worthiness. It will show what types of credit you currently have and/or what you have had in the past. It also shows whether you have paid your bills on time, filed for bankruptcy, or been evicted from a rental property. It is important to make repairs to your credit history before you apply for a mortgage loan.

Your credit history will impact the interest rate and terms of a loan, the minimum amount of the down payment, and even your likelihood of receiving a loan at all. Get a copy of your credit report from one or all three major credit reporting agencies (Equifax, Experian and TransUnion).

Go to to get a no-cost, no-gimmick copy of your credit report from each of the three major consumer credit reporting agencies. Review your report and .

To find out more about how your credit score is calculated, read the Bills.com resource . This should give you a much clearer understanding of how credit scores work.

Debt to Income Ratio (DTI)

One of the first factors a lender will consider when deciding how large a mortgage loan you qualify for is your debt to income ratio, or DTI. To calculate your DTI, add up your current monthly debt (credit card payments, car loans, etc.) and divide it by your total monthly pre-tax gross income. This ratio is a simple way of showing how much of your income is available to make a mortgage loan payment after all other continuing debt obligations are met.

Lenders often call this the 28/36 qualifying ratio. The first number, 28 percent, indicates the maximum amount of your monthly pre-tax gross income that the lender allows for monthly housing expenses. This amount will include principal and interest of the loan, property taxes, and homeowner’s insurance, or PITI. The second number, 36 percent, refers to the maximum percentage of your monthly pre-tax gross income that the lender allows for all monthly housing expenses plus all recurring debt.

If your ratio numbers are higher than 28/36, you may want to consider reducing debt by paying off credit cards or other loans before starting your home search. When calculating and relying on your DTI to determine loan affordability, be confident with your numbers and do not be afraid to stick with them as you shop around. Some lenders may be willing to loan you amounts that will take you beyond the traditional qualifying ratio - and beyond what you can afford. This could lead to more costly monthly payments and might cause financial hardship if you find that your loan is not affordable once you have moved into your new home.

Down Payment

The down payment is part of the purchase price of a property that the buyer pays, usually in cash, and is not included in the loan amount. Most lenders require five to 20 percent of the purchase price of the home, depending on the type of mortgage loan.

Review your budget and make a decision about how much of a down payment you can reasonably afford to pay. If you do not have enough, you may be able to qualify for a loan under various available.

Next Steps

Download a (Form 1003), complete it, and start mortgage shopping. Go to the Bills.com for no-cost, pre-screened quotes from mortgage lenders.

I hope this information helps you Find. Learn & Save.

Best,

Bill

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