What to Know About Paying Off Your Mortgage Early
A few things to consider about what mortgage prepayment means for your finances and liquidity.
Buying a home can be as nerve-wracking as it is thrilling and, for many prospective buyers, applying for a mortgage is the most stressful part of the process. After all, in applying for a mortgage, your financial and employment history are opened to scrutiny, and you may have the real fear that past mistakes will come back to haunt you.
Learning about the major factors that impact your mortgage application is an important first step in the path to homeownership. As you’ll see, most of these factors are ultimately within your control, which means you can work to improve your odds of getting a mortgage—either by bettering your overall financial profile over time or by seeking a lender that’s the right fit for you and your situation right now (take heart: chances are the right lender is out there!).
Before we dig into the individual reasons mortgage applications are often denied, it’s important to make clear that lenders are all unique when it comes to the applications they accept and deny. Different lenders have different thresholds for factors like credit score and debt-to-income ratio that play a role in mortgage application decisions. What this means is that while one lender may deny your application, it’s perfectly plausible that another lender may give you the green light, possibly even for the exact same mortgage product.
The reason has to do with something called lender overlays. As Dan Green, founder of the mortgage education website Growella explains, “an overlay is just an additional hurdle to approval that a lender decides to enforce.”
Let’s back up a minute. Banks and mortgage lenders originate loans to individual home buyers—this means that they pony up the cash that allows borrowers to purchase a home in the first place. And these banks and lenders are able to issue mortgages at a much higher volume because they typically don’t keep the loans they originate on their books for very long. Instead, they turn around and sell the mortgages to government-sponsored enterprises like Fannie Mae and Freddie Mac (in the case of FHA loans, the government actually insures the loan itself, allowing lenders to work with borrowers with lower credit scores and/or incomes). While Fannie Mae, Freddie Mac, and the FHA don’t actually issues loans, they set lending guidelines (which become industry-wide minimum standards) to ensure that the loans they purchase or insure aren’t too risky.
But most banks and lenders don’t simply apply the minimum guidelines as laid out by Fannie, Freddie, and the FHA. Instead, they apply their own in-house overlays, which may vary depending on the type of loan offered. For example, the FHA’s minimum credit score requirement is 500 (assuming a 10% down payment), but many individual lenders that work with the FHA raise that minimum requirement. Overlays are used by lenders to further reduce the risk associated with the mortgages they issue, in part because the overall quality of each lender’s portfolio of mortgages is assessed by the partners that purchase from them—Fannie, Freddie, and the FHA. At the same time, of course, these overlays “make it tougher for buyers to get mortgage-approved and lead to a lot of turndowns,” Green explains.
Overlays can make the mortgage application process feel more opaque and confusing, but there’s a silver lining: Because different lenders use different overlays, a turndown from Lender A doesn’t necessarily mean a turndown from Lender B. “There are so many available mortgage programs for homebuyers that, if there is a turndown, many times it’s because there’s a mismatch between consumer and lender; it’s not low credit or being brand-new to a job,” says Green.
With all of that in mind, let’s take a look at the top factors that can lead to mortgage application denials.
Whether you go through a traditional bank or a mortgage lender, your debt-to-income ratio is one of the most important elements of your mortgage application. This ratio is a simple measure of how much debt you carry expressed as a percentage of the amount of money you earn before taxes and deductions each month.
To figure out your debt-to-income ratio, add up all of your monthly debts (including student loans, car payments, credit card bills, and other loans with fixed payments, but not including utilities bills and other variable monthly expenses) and divide it by your gross—or pre-tax—monthly earnings. Most mortgage lenders are looking for a debt-to-income ratio that doesn’t exceed 43%, and that includes the mortgage payment you are applying to take on.
If your debt-to-income ratio is too high to consider taking out a mortgage at the moment, that’s a good sign that it’s time to focus on paying down debt before doing any serious house-hunting.”
Let’s say you earn $50,000 annually—or $4,167 monthly before taxes and deductions. In terms of debts, you have a $400 monthly car payment, $350 per month in student loans, and $125 per month in credit card bills. That’s $875 per month in debts, which gives you a debt-to-income ratio of 21%, not including a mortgage. Since 43% of your gross monthly salary is $1,791, you can likely apply for and be awarded a mortgage of around $900 per month. By paying off any one (or more) of your debts, you’d free up more money to go toward a potential mortgage.
There are some exceptions to the 43% rule, but in general, this is the number you want to keep in mind when you do your initial debt-to-income ratio calculations. Not only does this tell you whether you are carrying more debt than most lenders are willing to work with, it will also tell you how much mortgage you can realistically hope to borrow.
If your debt-to-income ratio is too high to consider taking out a mortgage at the moment, that’s a good sign that it’s time to focus on paying down debt before doing any serious house-hunting.
One last thing. When it comes to your debt-to-income ratio, debt is debt no matter the form. But it’s worth mentioning a recent trend: rising student loan debts are now making it harder for millenials, in particular, to become homeowners.
Jim Quist, president and founder of NewCastle Home Loans, based out of Chicago, has seen the trend play out firsthand. “Recently, we’ve seen an increasing number of mortgage applications we must deny because applicants have too much student loan debt,” he says. Income-based student loan repayment plans, which can help reduce monthly payments, are a good first step to consider. However, Jim cautions that it may still be harder to get a mortgage, even after getting on a reduced payment plan. “Some mortgage programs don’t allow lenders to use reduced payments to approve loans,” Jim explains. “FHA, for example, requires lenders to use 1% of the current student loan amount. Someone with $50,000 in student loans must qualify with a $500 monthly payment even if their income-driven payment is only $100 per month. Unfortunately, we’ve had to turn down many home buyers because they just don’t meet FHA debt-to-income requirements.”
This is another biggie. As you probably know, credit scores are used by lending institutions to assess each individual’s creditworthiness based on their financial history, including payment history (on-time versus late or missed payments), total amount of debt, length of credit history, and other factors. Credit scores, which are measured slightly differently across three major reporting agencies, range from 300 to 850 and are considered to be an at-a-glance measure of the trustworthiness of individual borrowers.
In general, credit scores below 640-670 are typically considered subprime and may make it more challenging to get a mortgage, especially with the most competitive interest rates. (If your credit score is in the subprime category, you aren’t alone: as of 2015, a little over half of American consumers—56%—were found to have subprime scores.)
Those with lower credit scores may still be able to get a mortgage—it will likely just require more shopping around (and having more cash on hand for a down payment is helpful, too). While Fannie Mae and Freddie Mac each require a minimum credit score of 620, the FHA has more forgiving parameters, making FHA loans a better bet if you are in credit-repairing mode.
FHA loans were created in the 1930s to make homeownership more widely accessible, and their guidelines stipulate that credit scores as low as 500 may be accepted with a 10% down payment. Credit scores of 580 or above, meanwhile, may be eligible with as little as 3.5% down. Remember, though, that you will need to identify lenders that don’t apply additional credit score overlays on top of these minimum requirements in order to actually score a mortgage with the lowest required scores.
Keep in mind, also, that anytime you apply for a new loan, you’ll typically accrue a “hard inquiry” on your credit report as your potential lender checks out your credit history. Too many hard inquiries can negatively impact your credit score, so if you know you will be applying for a mortgage soon—or if you’ve already been pre-approved for a mortgage—you’ll want to avoid applying for any other loans (like credit cards or car loans) until after you’ve secured your mortgage.
Your employment history is another major factor when it comes to your mortgage application. In general, most lenders want to see at least two years of consistent of employment history at the time you apply for your mortgage.
Requirements may differ depending on whether you are paid a salary versus hourly wages, work part-time versus full-time, and whether you are employed or self-employed. Note, too, that different lenders may handle income from things like a second job and overtime differently; these sources of income may not always be allowed to count toward your overall income on your mortgage application. Given these variables, you should be sure to tell potential lenders the details of your employment situation at the outset to make sure you don’t hit any unforeseen bumps in the road.
If, after approaching a handful of lenders, you find that your employment history is a little too spotty, now may be the time to focus on remaining consistently employed for a year or two before applying for a mortgage.
Occasionally, a mortgage application may be denied because of issues with the property itself and how it is valued rather than your own personal information.
Remember that the sale price of a home may not always correspond with the appraised value of the home. The appraised value is based on local comps, or other comparable houses that have recently sold in the same area, and other factors. Because the house you are buying will be used as collateral against your home loan, lenders use appraisals to confirm that the mortgage amount you are requesting is in line with the actual value of the house. If the appraised value is significantly lower than the agreed-upon sale price, you’ll either need the seller to come down off their price, or you would need to pay the difference out of pocket.
Note that especially unique properties—think geodesic domes and other, less striking examples—may come up against appraisal issues because of a lack of relevant comps.
Ready to apply for a mortgage? Here are a few strategic tips to help improve your odds of a good outcome.
The first step in preparing to apply for a mortgage is to check your credit and make sure you have a good idea of where things stand. You’ll want to get a copy of your actual credit report (which is typically available annually at no charge) and check your credit scores, too. Keep in mind that free credit score services typically don’t provide the same version of your scores as lenders use, so you may want to pay for your official FICO scores from all three reporting bureaus (Experian, TransUnion, and Equifax) to make sure you’re seeing the same numbers as your potential lenders.
Even if you’re pretty sure you’re not every lender’s ideal candidate, chances are you’ll get a better deal if you talk with at least two potential lenders before deciding where to apply. One thing to be mindful of: shopping around is smart, but as previously mentioned, multiple hard inquiries from loan applications can reflect negatively on your credit score. The good news is that FICO considers all hard inquiries made within a 45-day period on a mortgage, car loan, rental, or student loan to be a single inquiry, so you can avoid credit score penalties by doing all your comparison shopping within a 45-day window.
Ask potential lenders about their minimum requirements (for things like credit score, debt-to-income ratio, employment history, and down payment) for the mortgage products you are interested in.
Lenders lend. If they don’t make loans, they go out of business, so mortgage lenders are always trying to find ways to continue to lend. There is a connotation that lenders are doing consumers a favor, but it’s the other way around—you are doing the lender a favor.”
This may seem counterintuitive, but if you know you have a potential weak spot or two on your application, be sure to mention these upfront to potential lenders. In doing so, you may avoid an unnecessary denial by learning which lenders are more likely to accept your application, warts and all.
Mortgage pre-approvals aren’t ironclad, but they are a solid indicator of an eventual approval so long as nothing major changes between pre-approval and final mortgage application. “I have seen people that have wanted to switch jobs or make major financial decisions in the middle of their application process,” says CORE New York real estate broker John Harrison. “Don’t do it. Every type of approval down to the final loan commitment is still usually contingent on something. If you change the scenario, you may pull the plug on the whole deal.”
If your mortgage application is denied, don’t fret—and definitely don’t assume that one denial means you won’t be able to get a mortgage. Start by figuring out why your application was denied. “Hear the fact of why your loan was not approved, and then you can talk to an industry person to say, ‘here’s why I was turned down, what do you recommend?’” Green advises. “Every mortgage lender evaluates loans differently, even through the same programs and loans. It’s helpful to know upfront what the issues are, because they will all come out anyway.”
Keep talking to different lenders, and chances are you’ll end up with an approved mortgage application when all is said and done.
Finally, it may help to put the mortgage application process in a different perspective. “Oftentimes you only hear terrible stories, so there is a feeling from the general public that it doesn’t make sense to apply because they think they won’t get approved,” says Green. He points to Fannie Mae’s monthly housing survey, which finds that around half of Americans think it would be difficult to get a mortgage, when in reality the the vast majority (75%) of all mortgage applications are approved—a number that is actually growing.
“The way consumers think about home loans is different from how lenders think of them,” Green explains. “Lenders lend. If they don’t make loans, they go out of business, so mortgage lenders are always trying to find ways to continue to lend. There is a connotation that lenders are doing consumers a favor, but it’s the other way around—you are doing the lender a favor.”
In the end, Green’s motto may be the best advice: “If at first you don’t succeed with your approval, apply, apply again.”
A few things to consider about what mortgage prepayment means for your finances and liquidity.
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