When you plan to build a home, it usually isn’t an impulse purchase. It is a big decision. Many think about building their new home for years. They dream and plan for the day they will be able to build the home they want for them and their family. Planning for how to fund the purchase of a new home should be thought about in the same timeframe.
If you will need a mortgage to achieve your new home goal, there are things you can start doing today to help make you successful. While you won’t go to a lender and get pre-approved for a loan two years before you plan to start building your new home, you should start taking care of some basic things today. There are four fundamental factors that influence your home purchasing power. By starting to improve them today, you may be able to dream bigger as you plan your dream home!
What are the Four Main Factors that Influence Your Home Buying Power?
There are four fundamental factors that play a significant role in determining how large of a mortgage you will qualify to get (a.k.a. your home buying power.) These are your monthly income, your credit score, your monthly debt ratios, and your down payment. If any one of these are lacking, or lacking significantly, your dream of owning or building a home can be significantly impacted. By starting today, you can make improvements in each area that can insure you can build the home you want when the time comes!
Your Credit Score
Mortgage lenders use your credit score to decide whether to approve you and at what rate. Construction loans typically require a higher credit score because, in their mind, the lender is taking more risk. Your credit score is the key indicator to a lender about what kind of risk you are as a borrower.
As part of your credit score they will also look at things such as foreclosures, missed or late payments and bankruptcies. While many people will use websites like CreditKarma.com or CreditSesame.com to track their credit score, the score those sites use isn’t the one that the lender will use in determining your credit score. Those sites use the VantageScore 3.0 score. Your lender will use your FICO score. More specifically, they will use a specific version of your FICO score that tries to predict how well you will make your mortgage payments if they provide you with a loan.
Getting ready for a mortgage – You want the highest credit score you can have when you apply for a mortgage. In addition to determining if you meet the minimum credit score requirement just to quality for the loan, it also is used to determine the interest rate you will get. A lower score means a higher interest rate. A higher interest rate can impact your debt ratios (which we will discuss later). Your FICO score should be around a 680 minimum for getting a construction loan. Some lenders may want to see a 700+ FICO score. Pay down debts and make all of your payments on time leading up to applying for a home mortgage.
Your Monthly Debt Ratio(s)
Debt that you owe makes up half of the picture of your debt-to-income (DTI) ratio. The less you owe every month, the more income can go toward your house payment. It doesn’t matter what you think, it matters what the lenders thinks you can afford to repay each month for your mortgage. There are two ratios used to determine that for you. They are typically known as your front-end ratio and your back-end ratio.
The front-end ratio is calculated by dividing your projected monthly mortgage payments by your gross monthly income (your income before taxes). Your projected mortgage payment will include the costs of the principal, taxes, insurance, and interest payments, collectively known as PITI.
You earn $60,000, which is $5,000 per month
Your PITI comes to $1,450 per month
$1,450 / $5,000 = 0.29, or a front-end ratio of 29%
Your lender will set the terms, or the limits, for conventional loans. Depending on the lender, expect a limit of 28% for the front-end ratio. Federal Housing Administration (FHA) loans allow for a maximum front-end ratio of 31% as of 2018.
The back-end ratio accounts for all of your debt payments in comparison to your income. Your lender will calculate this ratio by adding your monthly debt payments and then dividing that number by your gross monthly income. These debt payments include the PITI on your mortgage, child support, car payments, credit card minimum payments, and any student loans.
Here’s an example:
You still earn $60,000, or $5,000 per month
Your PITI is still $1,450 per month
You have a credit card balance with a $75 per month minimum payment
You have a car payment of $200 per month
Let’s determine your back-end ratio:
Your monthly debt payments come to $1,725
$1,725/$5,000 = 0.345, or 34.5%
Most conventional lenders prefer to see a back-end ratio under 36%. Per FHA guidelines, lenders cap your total DTI ratio at around 43% — including your future house payment. So the lower your other minimum monthly payments (credit cards, student loans, car payments), the more house you can afford.
Getting Ready for a Mortgage – Make sure you add in your co-borrower’s debts that don’t show up on your report (things such as student loan or car payments). If you need co-borrower income to qualify for your home mortgage, lenders will add up the total monthly debts to get your household DTI ratio. In addition to increasing your income, make sure you hold a steady job as the source of that income.
Your Monthly Household Income
Your income is the second half of your debt-to-income (DTI) ratio. Lenders want to see that you’re making enough to cover your home mortgage payments and still have enough left over to pay your other bills. That’s why they cap your total monthly debt payments (including both current debt and your future house payment) at about 43% of your monthly income. Because your debt ratio is just that, a ratio, you can improve it by lowering your debit or increasing your income. Maximize your income, with as much documented history of it, prior to applying for a loan.
Getting Ready for a Mortgage – If you have a co-borrower, you can add their income to yours. However, you must include their debts AND their credit score. If they have large debts, it can negatively impact your ratios, you may want to determine if adding them is actually beneficial to your mortgage application. In addition, any credit blemishes on their credit report may now count against you by including them on the home mortgage application.
Check how much income you reported on your taxes last year, especially if you changed jobs or work for yourself. The number lenders care about is how much you reported to Uncle Sam (not what you say you actually made). Also, changing jobs just before or during the home mortgage application process can impact your ability to qualify.
Your Down Payment
Down payment options vary across lenders and government back programs. For example, some mortgage types let you put down as little as 3% (or maybe even nothing at all, if you qualify for a VA loan). But when building a home, be aware that many programs are only available for your long term mortgage, not your construction loan. Unless you are paying cash for your home, building a custom home will typically require a construction. Because the construction loans is considered riskier by bank they usually want some money down (What if something happens in the middle of construction and the bank has to foreclose. How hard is it for them to sell a half built home?).
Putting down more will help you lower your monthly payment and interest rate. If you put down less than 20%, you’ll probably need to get private mortgage insurance (PMI), which tacks on extra costs to your monthly payment. If have great income, great debt ratios, and great scores but little or no money down, you may be limiting the maximum amount the lender will provide based on the percentage down you have to provide.
Getting Ready for a Mortgage – First of all, start saving for a down payment as soon as possible. In some cases, you may be able to take a distribution from a 401K plan to fund a down payment. There are certain programs that offer grants for down payment assistance. Some loan programs allow for limited gifts from relatives to help with increasing your down payment.
Don’t forget, you may also need to have some amount of reserves in savings to make sure you can cover the first payment and incidental expenses. These funds will be subtracted from what you think you for a down payment.
Get More with Modular
When you decide it is time to build your new home and you know you will need to finance it, don’t wait. The very first place you should go is to a construction loan lender and get qualified for a loan. It is important to know if you qualify, and how much you qualify for when you start the actual search for your new home plan.
A home built using modular construction is treated just like a home built on site for conventional 30 year or 15 year mortgages. However, there are some slight differences in when it comes to how the construction loan works for modular homes. Modular construction takes the big bang approach. On site, a modular home shows up about 75-80% complete because it was built offsite. Because more is completed off site, factory efficiencies mean modular homes a built at a better value, with better quality, and with the ability to build using almost any design style. Modular means more!