The good news is that even if your finances aren’t perfect—maybe your credit score is below average or you don’t have 20% saved for a down payment—you still can qualify for financing. Here’s what else you need to know so that you can be financially and emotionally prepared for the homebuying process.
Down Payment Recommendations
When you finance a home, you’re required to put down some money upfront. Although you may be able to put down as little as 3% on a conventional mortgage, experts often recommend at least 20%, because this allows you to avoid paying private mortgage insurance (PMI) and to qualify for better terms. While that’s an industry recommendation, setting aside that much cash for a home purchase can feel like a massive undertaking, and in some cases, it’s not realistic. For example, the racial wealth gap means that on average, Black Americans do not hold as much wealth as their White counterparts. In fact, the median White family’s wealth is eight times that of a Black or Hispanic family’s, according to Urban Institute research. Not only are Black men paid an average of 87 cents for every dollar a White man earns (and the gap is even worse for women of color), but they have also been systematically shut out of intergenerational wealth-building, according to Shashank Shekhar, CEO of InstaMortgage. “Home equity is the largest financial asset for most middle-income households,” he told The Balance by email. For all first-time homebuyers, there are programs that can help ease the financial burden of saving up for a down payment:
Government-backed mortgages: Certain types of mortgage loans are insured by the federal government, allowing lenders to loosen their requirements. For example, Federal Housing Administration (FHA) loans allow you to put down as little as 3.5% with a credit score of at least 580, or 10% with a score of 500. VA mortgages have no minimum credit score or down-payment requirement, though individual lenders may institute their own minimums. Loans through the Rural Housing Service from the USDA have favorable terms for low-income borrowers in eligible areas. Down payment assistance programs: These programs, which provide funds for mortgage down payments and closing costs, are often designed for lower-income borrowers and typically are administered at the state level. They can come in the form of grants (these don’t have to be paid back), forgivable loans, loans with low or deferred interest, and more. To find a down-payment assistance program near you, check with the U.S. Department of Housing and Urban Development (HUD) or your local or state housing agency.
Credit Score Expectations
Another important factor in qualifying for a mortgage is your credit score. This is a three-digit number that tells lenders how trustworthy you are when it comes to borrowing money. It’s a tool that’s used to gauge how likely it is that you will pay back your debt, and it dictates your interest rate, loan terms—and even whether you’re approved at all. For instance, FICO (the scoring model most commonly used by mortgage lenders) typically doesn’t consider recurring payments such as rent, cell phones, and cable service when calculating scores. “Even with perfect payment history, these accounts go unnoticed and do not accurately reflect a future homebuyer’s level of financial responsibility in a way that their credit score could benefit from it,” credit expert and educator Jasmine McCall told The Balance in an email. Further, McCall said, many Black families don’t get credit cards until later in life. Therefore, they start the credit-building process at a later stage and often do not have as strong a credit score during the homebuying process as their White counterparts. “This creates an avenue for less buying power and a higher down-payment requirement, which may not be feasible for Black Americans that are already living within or below the poverty line.” Debt claims against individuals also have a very negative impact on credit scores, and data shows that Black people are often disproportionately targeted by debt claims and collectors. As such, the median FICO score for Black consumers is 125 points lower than the median score for White consumers. It’s estimated that the number of Black households with a mortgage would increase by around 11 percentage points if their credit scores matched White households’. That said, statistics should not deter you from pursuing homeownership. Minimum credit score requirements can vary greatly depending on the type of mortgage you are applying for. “People think that having an 800 credit score is the only way to get a home. You don’t need to have perfect credit to get a mortgage,” said Kara Stevens, author, and founder of The Frugal Feminista, during an Instagram Live conversation with The Balance on Feb. 8, 2022. “For example, if you want to be under an FHA loan, a credit score of 500 is par for the course. If you are a veteran that served our country, you may need a score in the low- to mid-600s, but each area is governed in different ways; they can set their minimums at different levels.” Although there are no minimum credit requirements for loans backed by the U.S. Department of Agriculture (USDA), a credit score of 640 is needed for its automated underwriting system. Otherwise, those with scores below 640 must go through the manual underwriting process, which has more stringent guidelines. Credit scores are a tool that lenders use to protect themselves, but they have no bearing on a person’s character or worth (even though it can sometimes feel that way). Unfortunately, there’s not much you can do about the role that credit scores play in the homebuying process, but there are steps you can take to strengthen yours. Most critically, be sure to pay all your bills on time, as payment history is the most heavily weighted factor, accounting for 35% of your score. If you have any outstanding debt—especially credit card balances—work on paying that down before applying for a mortgage. “Amounts owed” is another significant credit-score factor at 30%. Keep in mind that it can take anywhere from six to 12 months for your score to increase significantly, so have patience during this process.
An “Acceptable” Amount of Debt
When applying for a mortgage, lenders will also consider how much of your income goes toward paying debt. This is known as your debt-to-income ratio (DTI) It’s calculated by adding up all your monthly debt obligations (including payments for car loans, student loans, credit cards, child support, alimony, and more) and dividing it by your monthly gross income. For example, if you pay $1,500 per month toward your debts and earn $6,000 per month before taxes are taken out, your DTI would be 25%. Student debt can be a particular hurdle when it comes to getting a mortgage. For instance, Black college graduates owe an average of $25,000 more in student loan debt than White college graduates. “Agencies like Fannie Mae and Freddie Mac will consider a certain percentage of the student loan balance as a monthly debt even if the debt is not required to be paid immediately,” Shekhar said. “This means that the more student debt you have, the lesser your chances of getting a mortgage since your DTI might be higher than the allowable limits for these agencies.” This is known as the 28/36 rule, which many lenders follow. However, some will allow a DTI as high as 45% to 50%. The best way to improve your odds of obtaining a mortgage when you already have a large amount of existing debt is to make yourself a more attractive borrower in other ways. That might mean putting down 20% or more, saving up plenty of cash reserves, or having an excellent credit score.
A Home You Can Afford
The above factors help lenders determine whether you can afford to buy a home, but you should also strongly consider what you can and can’t afford. Just because you qualify for a mortgage on paper doesn’t mean that the loan and property won’t be a financial burden. So it’s important not to buy more home than you can afford. “It brings your quality of life down because it’s too expensive,” Indira Ranganathan, an attorney and real estate agent, told The Balance in a phone interview. “I think we have collectively, as Americans, bought into a narrative for what a home should look like in terms of square footage,” Stevens said. “For many of us, homes are a marker of success, and more success means more house. While in other countries, such as Japan where space is at a premium, just having a space is reason to celebrate. There are so many options for what a home can look like.” For some homeowners, the property itself can serve as a source of income. For instance, you might purchase a townhouse or multifamily property and rent out part of the space or vacant units. While this can be a great way to earn additional income, it also comes with a host of expenses and challenges. “Do you really want the responsibility of having a home?,” Stevens added. “Lots of people think about the purchase but not the maintenance. Are you prepared for when homeownership is not the dream you imagined, like burst pipes and termites? You have to be prepared for the worst possible situations, too.” Ultimately, you’ll need to decide what type of lifestyle you want. Then determine how homeownership will fit into that picture and help you achieve your goals.
All the Documents
Because so much financial information is required when applying for a mortgage, you’ll need to supply quite a bit of documentation. Ranganathan said that one of the hardest parts of buying a home is gathering all of your financial information in one place. She noted that it’s a bit easier now that you can find most of this information online. “But the process of doing it is very difficult … emotionally because it forces you into a place where you have to assess everything,” she said. It can feel like the bank is asking whether you’re worthy of owning a home. As there is a lot of information to pull together within a short amount of time, it can be helpful to gather your financial documents ahead of time. Typically, you can expect to provide:
One to two months of paystubs Two years of tax returns Three to six months of bank account and investment statements, including checking and savings accounts, retirement savings, and other brokerage accounts, etc. Statements related to any debts you currently owe Miscellaneous documentation specific to your financial situation. For example, if you were gifted your down-payment funds, you will need to provide a gift letter. Or if you recently made a large withdrawal from your savings, you’ll need to explain why.
Note that if you’re self-employed, you’ll need to provide additional documentation to show that you have sufficient income to handle a mortgage payment, paperwork such as proof of business license and insurance, letters from clients, profit-and-loss statements, and more.
Mental and Emotional Stamina
Finally, it’s just as important to be mentally ready for the homebuying process as it is to be financially prepared. The various steps you go through and the information you share can be emotionally draining, according to Ranganathan. “Especially for people of color,” she said, “who might not have that generational wealth behind them.” Ranganathan noted that hiring the right professional can help you through the process. “They will take into consideration you as a person and your emotional and financial well-being on top of just showing you a home,” she said. “So choosing the right real estate agent and finding someone who connects with you as a person is very important mentally.”
Resources for Black Homebuyers
Throughout February, The Balance is addressing addressing racial homeownership gap and discrimination issues through a series of guides and social conversations. These resources are for all first-time homebuyers, but will offer additional advice and tips for Black homebuyers who are preparing, shopping for, and moving into their first home.“The goal is not just to buy a home, it’s to stay in a home and have a joyful life,” Stevens said.
