There are three critical factors that determine how much you qualify to borrow, and the rate and terms for your home loan:
- Your credit history, or FICO score
- Your capacity to repay, or debt-to-income ratio
- Your home’s collateral value, or loan-to-value ratio
Most lenders use a rating based on your credit history to check your credit. Fair Isaac Corporation (FICO) gathers and collates information from the “big three” U.S. credit reporting agencies (Experian, Equifax and TransUnion) to create your credit report.
The information compiled in your credit report includes basic data such as age, Social Security number, current and previous addresses, employers and marital status. It also looks at information on your borrowing history from credit card issuers, mortgage lenders and other sources. It generally includes all of the credit relationships you have, the date they were established, the maximum allowed credit, your current balances and your payment history.
The combined information is then used to calculate your “aggregated” credit score or FICO rating, a number between 300 (lowest) and 850 (highest). As a rule of thumb, higher FICO scores result in lower interest rates and more favorable terms. With some exceptions, the best rates and terms go to borrowers with the best — approximately 740 or higher — credit scores.
Capacity to repay
Among other things, lenders consider your capability to afford the payments associated with your loan when determining if you qualify for the loan. One way to do this is to evaluate your overall indebtedness compared to your total income to arrive at your debt-to-income ratio (DTI).
For example, if your monthly debt payments total $2,000 and your income (your annual income before taxes or other deductions divided by 12) totals $6,000, your DTI is 2,000 divided by 6,000 (.33). In other words, one-third of your income currently goes to debt payments.
DTI indicates whether you have the capability to take on an additional debt payment. A high DTI may indicate that you already pay too much to service current debt and taking on a new loan would be risky for you and your lender. In terms of mortgages, a DTI less than 36% is preferable, with no more than 28% of that debt going toward your mortgage. (For other debt, being at or below 15% is better.) In general, the lower your DTI, the better chance you’ll have of getting the loan or line of credit you want.
Collateral is the value of your home as it relates to the amount you’re borrowing. It’s expressed as a loan-to-value ratio (LTV). For example, if your loan value is $175,000, and your home (or the home you intend to purchase) appraises at $250,000, the LTV would be 70%.
Like DTI, the LTV indicates something about the level of risk to you and your lender, if you take out a loan. A lower LTV reduces the risk. A high LTV — greater than 80% — may indicate an unacceptable level of risk. This could mean you may be required to mitigate the risk through Private Mortgage Insurance (PMI), which is insurance that reimburses the lender if you default on your home loan. You, the borrower, would pay the premiums for that insurance until your PMI is cancelled when your outstanding loan balance drops to 78% of the home’s original value.
FICO, DTI, LTV, PMI…that’s a lot of acronyms to understand! If you’re sending an “SOS” about any of these topics, First Internet Bank is here to help answer any questions or find the best financing option for you. Give us a call at 1-888-873-3424.