The importance of credit, debt, and savings when buying a home

Before you start the homebuying process, be sure to look in-depth into your credit score, debt, and savings. These three pieces of financial information may have a large impact on your ability to qualify for a loan and get a competitive interest rate. Below is a breakdown of the importance of each.

Your overall credit is a measure of how you’ve managed loans, credit cards, and other payments in the past. It’s compiled into a credit report and calculated into a credit score, which is used by lenders to evaluate your ability to pay back debt. 

As you prepare your home shopping journey, start by obtaining a copy of your credit report early, for instance, on annualcreditreport.com. You’ll likely see a variety of credit-related accounts, such as credit cards, existing loans (like auto or student loans), and more.

Credit scores range from 300 - 850. A high credit score generally means you’re managing your credit well, not borrowing more than you can afford, and paying all reported bills on time. This can translate into more favorable mortgage terms and even a lower interest rate. 

When you apply for a home loan, lenders will examine your debt to determine the risk associated with you taking on another payment. They use a calculation called debt-to-income (DTI) ratio. While debt isn’t necessarily viewed negatively on a loan application, you’ll want to ensure your total debt doesn’t exceed a certain percentage of your income. Having a DTI ratio of 35% or less is a good rule of thumb.

On the other hand, having no debt, lines of credit, or credit cards could actually lower your credit score because you aren’t building a history of good credit habits.

Lastly, it’s important to know that making large purchases with loans or credit cards, or opening a new credit card account just before applying for a mortgage, may impact your credit score and ability to qualify, so consider your needs and priorities carefully. 

If you’re considering buying a home, you’ll need to have cash on hand to cover expenses, including your down payment and closing costs, which include origination fees for the mortgage, legal expenses, and more. You’ll also need to pay for the costs associated with closing on your home, which include a home inspection and an earnest money deposit. Most lenders look at your savings to also ensure you have enough money to cover several mortgage payments, taxes, and insurance payments on a home.

Lenders will also want to verify the source of your closing and down payment funds, including whether a portion of your down payment is from savings or a monetary gift from a family member, friend, employer, or nonprofit organization.