Most people don’t have the cash to buy a house outright, so they must take out a mortgage to pay for it. In deciding whom to approve for a mortgage, lenders generally hold to the same standards involving credit scores, income and debt. This post explains how you can improve your chances of qualifying for a mortgage.

Credit

Lenders in the United States typically use the FICO credit scoring model, which places the greatest emphasis on making payments on time. One of the most effective ways of meeting this requirement is to arrange for all your bills to be paid automatically. If you’re not comfortable with automatic payments, you should set aside a specific time every two weeks to pay your outstanding bills. This approach is often necessary when your income is unpredictable.

Your credit utilization ratio is the second most important factor in the FICO model. This value is the ratio of the total amount you owe on your credit accounts to the total amount of credit available to you. High credit utilization will lower your credit score, so it’s important to reduce your balances as much as possible before applying for a mortgage.

Your credit history is the next biggest component of your FICO score. A long credit history increases your credit score, so you shouldn’t close your oldest accounts unless they require an annual fee. You should also avoid opening a large number of credit accounts within a short period of time, as this would reduce the average history on your accounts.

Another factor that the FICO model takes into account is credit mix, which is a measure of the variety of credit accounts you have. Credit may generally be classified into revolving and installment types. Revolving credit primarily includes credit card accounts, while installment credit includes loans requiring regular monthly payments. A mix of both types of credit will increase your credit score, although it’s a comparatively small factor.

An application for new credit will bring about an inquiry into your credit history, commonly known as a “hard pull.” It can temporarily reduce your credit score by three to five points, although it will drop off your score within a few months, depending on the credit reporting bureau. These bureaus promote lender shopping by counting only one hard pull against your credit when you apply multiple times within a short period, typically two weeks. Lenders like Figure can provide you with a loan quote that won’t affect your credit score by doing a “soft pull” that just checks your score. A hard pull isn’t needed until you actually apply for the loan.

Debt vs. Income

Your debt to income (DTI) ratio is your total debt payments for a given time period divided by your total income for the same period. Mortgage lenders use your DTI to help determine how difficult it will be for you to make the payments on your new loan. They typically look for a DTI of less than 40%, with less than 30% of your income going toward your house payment.

Refinancing

Refinancing involves replacing your original mortgage with another mortgage loan. Many homeowners can benefit from refinancing once they’ve built up equity in their homes through a history of making monthly payments. Equity represents the amount of the value of your house that you actually own. Homeowners typically refinance during periods of declining interest rates, resulting in lower monthly payments, shorter loan terms, and less cost over the life of the loan.

Equity

You can calculate equity by subtracting the balance on your mortgage from the market value of your house. Divide this difference by the market value of your house and multiply by 100 to obtain your equity as a percentage of the home’s value. Assume for this example that your house is worth $300K and your mortgage balance is $240K, which means your equity is $60K ($300K - $240K). Your equity is therefore 20% (($60K/ $300K) x 100) of the value of your house.

You’ll generally need at least 20% equity to get the best refinancing offers. You may be able to refinance with as little as 5% equity, but you should expect to receive less favorable terms. At a minimum, lenders will require you to pay for mortgage insurance as long as your equity is below 20%. If you owe more on the house than what it’s currently worth, you’re considered to be “upside down” because your equity is a negative value. In this situation, you should put off refinancing and consider other options such as restructuring your existing mortgage.

Appraisals

Lenders need to know what your house is worth when reviewing your application for a refinance. The appraisal is often the most time-consuming part of the refinancing process, because the lender has to schedule the appraisal, wait for the appraiser to perform the appraisal, and then wait for the appraiser to provide the report.

Some lenders require an average of 39 days to close on a loan, which is the time needed for you to receive the funds after you apply for the loan. Lenders with applications that can be completed entirely online have significantly shorter closing periods, because the paperwork needed to verify your income and assets can be gathered automatically. For example, Figure can close on refinances much faster than other options, depending on the time needed to complete the appraisal.

Summary

Nearly everyone needs a mortgage to buy a house, so you need to ensure you’ll qualify before you start looking for your next home. Factors such as your credit score aren’t easy to change quickly, which means you need to start planning your purchase well in advance of needing a mortgage. The first mortgage for many homeowners has a relatively high interest rate due to their lack of established credit and savings. However, they can often obtain a significantly lower interest rate on a refinance once their financial situation improves.