Key Home-Buying Terms to Know
As you begin the home buying process, you'll likely encounter a host of home purchasing and borrowing terms, some familiar and others technical.
The most common phrases include:
Debt-to-Income Ratio: Typically expressed as a percentage, your debt-to-income ratio (DTI) is calculated by dividing your monthly debt payments by your gross monthly income (i.e. your income, before taxes). Click here to calculate your DTI.
Down Payment: This is the amount of cash you put towards the purchase price of the home upon closing. A typical down payment ranges between 3 to 20% of the home price, but could be more. The average first-time homebuyer pays a 7% down payment.
Pre-Qualification: After you submit your financial information to your lender (like your reported debt, income, and assets), you’ll get a general estimate of how much money you can expect to borrow. Pre-qualification is an early step in your home buying journey and is not an official guarantee of a loan.
Pre-Approval: After the lender verifies your financial information, they will provide a pre-approval letter that represents their conditional offer to lend you a specific amount of money. Note that this is still not an official commitment to lend you money. Still, with a pre-approval letter in hand, you may have the advantage when dealing with sellers as you can demonstrate your ability to secure a mortgage.
Closing Costs: Beyond the down payment, closing costs are the various fees and expenses incurred when obtaining a mortgage, and they often include things like preparation and title search fees, discount points, attorney fees and credit report charges (also known as settlement costs). Typically, closing costs are worth 2 - 5% of your total loan amount and are paid at the very end of the process.
For example, if you bought a $200,000 house, your closing costs would likely range between $6,000 to $12,000.
Credit Score for Buying a Home
Lenders will typically check a borrower’s credit twice throughout the home buying journey: at the beginning of the approval process and just prior to closing.
In order to understand how best to raise your credit, it’s important to know what metrics define your FICO® score in the first place.
Individual FICO® scores are determined based on the following five factors:
- Payment History — 35%
- Amounts Owed — 30%
- Length of Credit History — 15%
- Credit Mix — 10%
- New Credit — 10%
You can check your credit score for free. In fact, it’s federal law that every consumer receives one free credit report every 12 months from each of the three nationwide credit reporting agencies.
Simply go to www.annualcreditreport.com to request yours today from one of the three national credit reporting agencies, Experian, Equifax, and TransUnion.
As you look over the report, be sure to review it closely and resolve any errors in reporting. After all, it’s not uncommon for credit reports to contain errors significant enough to negatively affect your creditworthiness.
To dispute and resolve any errors, it’s best practice to contact the company that provided the erroneous information on your account and the credit reporting agency directly.
Once you’ve resolved any disputes, consider following these five tips to help raise your score.
1. Make Payments On Time
Payment history is the most important factor in your credit report. After all, it accounts for 35% of your FICO® score.
Lenders value consistency in financial behaviors, whether that means paying medical bills on time or submitting your monthly rent before the first of every month.
Late payments that are reported to the credit reporting agencies can damage your credit report years at a time. For example, delinquencies (i.e. missed or late payments) can remain in your credit report for up to seven years — even after you’ve paid the past-due balance.
2. Turn On Auto Payments
If setting a reminder in your calendar isn’t effective enough, turn on auto payments to more efficiently manage your incoming bills.
And what are auto payments? They’re scheduled payments that automatically complete recurring bills (like gym memberships, phone bills, and credit card statements). You can easily set them up through your bank or credit issuer.
This is a great way to avoid delinquency and ensure that all of your bills are paid on time, without requiring you to even think about it. Just be sure to time your auto payments correctly, so they are completed either on or before your due dates.
3. Keep Your Debt-to-Income Ratio (DTI) Low
Debt management is crucial to financial health (and maintaining higher credit scores). More importantly, your debt-to-income ratio is a key indicator of your ability to make monthly mortgage payments on time.
Excessive debt is one of the top reasons mortgage applications are rejected.
For the sake of example, let’s say you make $5,000 a month in pre-tax income. Of that money, $2,000 is owed in monthly payments for outstanding debts, with the remaining $3,000 left to cover your living expenses.
In this case, your debt-to-income ratio (DTI) would be 40%, a little bit above the preferred range of 36%.
Fortunately, there are a few ways to decrease your DTI:
- Increase the amount you pay each month towards your debts.
- Tackle high interest debt first.
- Control (and limit) your non-essential spending.
- Postpone applying for additional loans.
- Reduce the amount you charge on credit cards.
4. Tout Your Renting Record
Believe it or not, your rental history can play a very positive role in purchasing a home.
Remember, mortgage lenders value consistency, so if you can demonstrate a reliable history of paying your monthly rent on time and abiding by the terms of your lease, they may look more favorably on your application — even if your credit history is less-than-perfect.
In fact, mortgage loan financer Fannie Mae recently decided to incorporate rent payments in mortgage applicants’ credit history review. This move empowers millions of borrowers to demonstrate their creditworthiness beyond the confines of their FICO® score alone.
5. Choose the Right Credit Card
Not all credit cards are created equal. That’s especially true if you’re in a credit building (or rebuilding) phase of life. Take a hard look at your credit goals, what you’re willing to give (annual fees, interest fees, etc.), and how they will affect you. In the end, choose a card that allows you to build credit and tackle debt.
Build a Strong Foundation
Building your home on good credit is an attainable dream. Lock in those useful credit terms, make timely payments, watch your debt-to-income ratio, let your good rental history be known, and be smart with your credit card choices. Making strong financial gains takes work, but it’s completely worth it!