If you’re thinking about applying for a mortgage to purchase a home, you will hear certain terms over and over again: credit, credit score, debt, income. Let’s look briefly at what those terms mean and how they might affect your ability to purchase a home.
Credit refers, in general, to situations in which you receive goods before you’ve paid for them in full. Credit is extended by banks, retailers, and other lenders based on evidence of a consumer’s ability to repay. We’re familiar with credit cards, which enable us to take home the groceries or books or clothes today, and pay for them later when billed. If payment is late, or if payment is extended over a long period, interest is added to the balance. Automobile loans and mortgages are types of credit.
Credit score is a measure of a consumer’s combined credit history and credit risk. In 1981, the Fair Isaac Corporation (FICO) introduced an impartial and consistent system of national credit scoring. In general, the elements that contribute to your score are:
- 35% payment history
- 30% amounts owed
- 15% length of credit history
- 10% new credit
- 10% types of credit
Credit scores range from 300 to 850; the higher the number, the better your rating. Lenders are generally looking for scores of 600 or higher. Loans are also available for borrowers with much lower scores – typically with larger down payments.
Debt refers to any recurring monthly charges that show on your credit report, such as car loans, alimony and child support, credit card bills, student loans, other loans, credit lines, and your mortgage. In general, although they are paid monthly, rent and utilities are not included, nor are health or auto insurance.
Income always refers to your gross (pre-tax) monthly income, and includes sources such as salary, wages, tips, pension, Social Security, bonuses, alimony, child support, repayments of personal loans, investment income, and any other regular payments you may receive.
When a lender is considering your loan application, one of the vital measures is known as the debt-to-income ratio (DTI). As the Consumer Financial Protection Bureau explains, “To calculate your debt-to-income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out … Evidence from studies of mortgage loans suggests that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments. The 43 percent debt-to-income ratio is important because, in most cases, that is the highest ratio a borrower can have and still get a qualified mortgage.”
Understanding the importance of debt, income, credit scores, and debt-to-income ratio is an important step in borrowing funds for the purchase of a home. If you have questions, or if you are ready to begin the application process, Sente Mortgage is ready to assist.