Loan prequalification vs. preapproval
One of the best ways to determine your budget is to have your real estate agent or lender prequalify you for a loan. Prequalification is different from preapproval, because it is only an estimate of what you'll be able to afford. On the other hand, preapproval is a more formal process where a lender examines your finances and agrees in advance to loan you money up to a specified amount.
What factors are important to lenders?
Banks and lending institutions will use several criteria to determine how much money they'll agree to lend. These include:
- Your gross monthly income
- Your credit history
- The amount of your outstanding debts
- Your savings--or the amount of money you have available for a down payment and closing costs
- Your choice of mortgage (i.e. 30-year, FHA, etc.)
- Current interest rates
Two important ratios
Lenders also use your financial information to figure out two, very important ratios: the debt-to-income ratio and the housing expense ratio.
Many lenders use a rule of thumb that the amount of debt you are paying on each month (car payment, student loan, credit card, etc,) shouldn't exceed more than 36 percent of your gross monthly income. FHA loans are slightly more lenient.
Housing expense ratio
It is generally difficult to obtain a loan if the mortgage payment will be more than 28 to 33 percent of your gross monthly income.
| Down payments make a difference
If you can make a large down payment, lenders may be more lenient with their qualifying ratios. For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.
Other ways to improve your purchasing power
If you're having trouble saving money, many lenders will allow you to use gift funds for the down payment and closing costs. However, most lenders require a "gift letter" stating the gift doesn't have to be repaid, and will also require you to pay at least a portion of the down payment with your own cash.
Negotiating Closing Costs
Through negotiation, some sellers may agree to pay all or most of your closing costs (for example, if you agree to meet their full asking price). If you choose to try this, make sure to ask your real estate agent for advice.