This is one spot that no one wants to end up in: you’ve found the house you want, your offer has been accepted, but it all falls through because you don’t have financing in place. Lenders deny mortgage applications all the time, and it pushes would-be homeowners back to square one.
So how do you avoid this situation?
If you’ve been thinking about a move or a first-time home purchase, you probably know that there are a lot of moving parts involved, and a ton of information out there about being financially prepared. However, if you can run through this list of five steps without a hitch, you’ll be in an extremely good position with respect to financing your new home.
If not, now is a good time to start looking at ways to get yourself on track, whether it’s changing your timeline so you can save up a larger down payment, or bringing on a friend or relative as a co-signer.
Before we get into the five main steps, let’s take a moment to mention that following these steps will be just as vital to getting your pre-approval as it will be for your final approval. While a pre-approval doesn’t provide a guarantee that your formal mortgage application will be approved, it is an important step in the home-buying process because, among other things, it lays the groundwork for a smoother application process and is a very strong indication that you will be successful.
Step 1: Build up good credit.
Generally, a credit score between 680 and 900 will help earn you a very competitive interest rate through a mortgage broker and, in the case of a lower score, they should still be able to help you find a lender that can accommodate you.
In terms of what determines your credit score, there are simply too many factors to get into here, but in broad strokes, there are two markings of good credit:
- You have Especially with young first-time buyers, a lack of credit history can be a roadblock to a mortgage approval. Make sure you have and disclose at least two sources of credit in your name, such as a credit card, car loan or student loans.
- You manage credit well. Your lender is trying to determine whether you can be relied upon to pay your home loan. If you look at your current loans and credit cards and you’re making your payments on time and on a consistent basis, there’s a good chance you’re building a good credit rating. If you’re regularly making late payments or missing them altogether, you’re doing damage to your score.
Step 2: Save up as much cash as possible.
In Canada, you need to pay at least 5% of the purchase price of a home in cash, in order to be approved for a mortgage. For houses above $500,000, any amount above that threshold requires a 10% down payment.
The more you put down, the less you have to borrow. More cash down makes it easier to get approved, and of course lowers your monthly payments, making your life easier through the entire amortization period. It often happens that waiting even a few months to save up can put you in a far better position to purchase a home, and put you in a far better light from the perspective of your mortgage lender.
You’ll need to be able to show where this down payment is coming from, so when applying for your mortgage pre-approval or approval, make sure you have the full list of documentation on hand, as these documents will help you paint a picture of your financial situation. Your lender will outline what is required, but these are the documents most commonly needed:
- Proof of employment
- Current pay stub
- Bank statements (i.e. proof of capital for down payment and closing costs)
- Information about other major assets, such as cars, cottages or boats
- Current mortgage or rental documentation
- Debt statements, including credit cards, child or spousal support, car loans, lines of credit and student loans
Step 3: Project stability.
Lenders are working to determine the likelihood that you will default on your mortgage. The lower the risk they perceive in your financial situation, habits and history, the less restrictive the mortgage agreement will be. You’ll be approved for a larger loan with fewer conditions.
First, try not to change jobs or residences in the months leading up to a home purchase. This type of change represents a degree of risk for the lender, and if you’re still in a probationary period at a new job, it could suggest there’s a chance you won’t continue to earn the income you need to pay your mortgage.
Another pitfall is an untimely major purchase. For example, if you decide to buy a vehicle shortly before applying for your mortgage pre-approval, your financial situation will be skewed, because such a purchase will affect your debt ratios, credit history, monthly expenses and, most likely, savings available for a down payment. This, in turn, could affect your mortgage approval and interest rate.
Keep in mind that a mortgage pre-approval typically locks you into an interest rate for 3-4 months, so if rates go up while you’re house hunting, you’ll still receive that original low rate when you purchase your home. However, this step does not lock you into one particular lender, so if you do not like the terms they’ve outlined, you can continue shopping around without penalty.
Step 4: Review your net worth and debt.
Your net worth is one of the key touchstones for your financial health. You should always calculate your total net worth prior to the application process, by totalling your assets (what you own) and subtracting your liabilities (what you owe). A positive net worth is a strong positive indicator for lenders.
Similarly, it’s essential to ensure that your Gross Debt Service Ratio (GDSR) and Total Debt Service Ratio (TDSR) are at healthy levels. These two ratios are vital to the approval process, so I encourage you to take a look at our recent article to get a full explanation of the terms.
Basically, this means that your total housing costs (including mortgage, property taxes, heating and, if applicable, 50% of condo fees) cannot exceed 32% of what you earn every month, and the cost of all of your debts (including housing costs, student loans, car loans, child support, etc.) must fall short of 40%-42% of your gross income. These debt ratios help mortgage lenders determine the mortgage size, type and payments that you should be able to afford.
Also keep in mind that as of January 2018, federally regulated lenders are required to perform a stress test even on those with down payments larger than 20%, in order to determine if you could continue to afford your payments should interest rates increase. How you perform on this stress test will help determine how large a mortgage you’re approved for in your initial pre-approval as well as your final approval.
Step 5: Pick the right house.
When your mortgage application is assessed, your lender must judge the risk involved in the loan. This means they’re not only looking at your situation, they’re also looking at what you’re buying.
If the home you want to purchase has asbestos, knob and tube wiring or other high-risk features, this could work against you in the mortgage application process. Also, if the lender has determined that the appraised value of the house is lower than the purchase price, they could deny your application. In other words, if they conclude that the house is worth less than what you agreed to pay for it, they won’t want to finance the purchase.
Picking the right house also means finding a house that is safely within your budget and well below the maximum outlined in your mortgage pre-approval. Going over-budget is seen as risky by the lender, but keep in mind that it’s also risky for you – as bad as it is to get denied the mortgage for the home you want, it’s considerably worse to get approved for a house that you cannot truly afford.
All this information about mortgage approvals can be overwhelming, but at the end of the day, you and your mortgage broker or lender should be able to balance all priorities and work out the terms that will enable you to finance the home that’s right for you. I welcome you to reach out to me directly, and I will help you determine where you’re doing well, and identify areas that could be improved upon as you work toward home ownership.