Why Credit is Important
Credit is a very important aspect of buying a home. A lender wants to make sure the borrower will pay back the money. In order to determine if an individual is a good credit risk, a lender looks at four things, called the 4 C’s of credit – capital, capacity, credit history and collateral.
The amount of cash you have available is your capital. The more cash you have in savings accounts, certificates of deposit, bonds or other places where you can get to the money quickly, the more comfortable a lender will be that you can cope with the financial emergencies that may arise after you move into your new home. If you have saved capital, it shows the lender that you know how to budget and manage your money.
Lenders will ask how much capital you have and where it came from. This is called verification of deposit. You will also need to show that you have at least enough capital to pay for the:
- Down payment
- Loan fees
- Closing costs
- Escrow impounds (advance payments for property taxes and insurance)
- Moving expenses
- Lenders typically want to see that you have saved this money for yourself, but they realize this is difficult for low-income buyers. Some loan programs allow you to use some of your own savings and some money you received as a gift or a grant in order to get the capital you need to qualify for a loan.
Your ability to earn enough income to make the new mortgage loan payments and still pay all of your other living expenses is called your capacity. Lenders need to see that you have the ability to repay your loan. Lenders calculate your capacity by looking at your current income, your income history and the amount you owe.
A lender needs to see that you (and your spouse, if you are married) currently earn enough to pay the new house payment and other expenses, such as taxes and insurance, and still live comfortably. A lender looks at your gross income, which is the amount you earn before taxes. This includes overtime pay, commissions, dividends and any other money that is part of your regular income. As long as you can show a steady history of income, the lender can count it.
A lender looks at your employment history and your future earning potential. A lender will ask:
- Can you show that you have held steady jobs and earned a stable income for the past two years?
- How long have you held your current job?
- Is it likely that you will continue to be employed as this rate of pay or better for the next two years?
A lender will ask for verification of employment. You can show your pay stubs, tax returns or other kinds of proof. A lender may contact your past and present employers to verify how much you earn and that you are likely to continue working there in the future.
The amount you owe
A lender will look at all your creditor debts, such as monthly payments on loans, charge cards, child support, etc. However, lenders do not include certain types of monthly bills, such as telephone and utility bills, auto and life insurance, retirement and savings contributions, income and Social Security taxes and union dues.
A lender wants to predict whether you will repay your loan. A good indicator is how you have handled your other debts. If you have always repaid the money you have borrowed on time, generally pay cash for things and save credit cards for large purchases and emergencies, you are probably a good credit risk. But, if you have many loans and credit cards and struggle to make the minimum payments that are due, you may need to improve your credit history before you apply for a home loan.
A lender orders a copy of your credit report to learn about your credit history. Read more about what is on a credit report and how to get a copy of your report.
Some people do not have a credit history because they have never used a credit card or borrowed money from a bank. Even if you do not have traditional credit, you may be able to get a loan for a home purchase. Click here to read about nontraditional credit histories and how you can create one. It is also important that you talk with a credit counselor.
Your new home will be collateral or extra security for your loan. Your lender will look carefully at the value and condition of the house to make sure it is worth at least as much money as you are borrowing and to be sure that the house does not have any major repair problems that could cost more money than you planned.
Lenders determine value by hiring an appraiser. You will be asked to pay for the cost of the appraisal when you apply for a loan. The appraiser uses his or her professional training to estimate the fair market value of the house. Because lenders want you to invest some of your own money in the house, they will generally lend less than the fair market value. The appraisal is used to calculate a loan-to-value ratio, which helps the lender determine how much to lend and tells you how much of a down payment you will need. To read more about the loan-to-value ratio, click here.
Lenders review the appraisal not just for value but also to make sure the house is in acceptable condition. If the appraisal shows that any major parts of the house are not in good shape, the lender may agree to make the loan only if the part is fixed. This is called property condition contingency. It is a protection for you as well as the lenders.
Information in this section was compiled from the “Realizing the American Dream,” workbook for homebuyers from the American Bankers Association, National Foundation for Consumer Credit, and Neighborhood Reinvestment Corporation.