Buying your first home is one of the most exciting events in your life. But, before you can sign the contract and get the keys to your new house, you must qualify for a mortgage, or home loan. In fact, it’s best to apply for a mortgage conditional approval before you even start looking at houses for sale. This process may seem overwhelming and intimidating, but understanding how it works can put your mind at ease.

What is a mortgage?

A mortgage is a loan secured by real estate. This type of loan allows you to purchase a home even when you don't have access to the full purchase price in cash. When you take on a mortgage, you’ll make payments every month. Each payment will include a portion toward the principal, which is the outstanding balance of the loan, as well as a portion toward interest.

In most cases, your lender will also make your property tax and home insurance payments on your behalf, so a portion of your monthly mortgage payment will go toward these expenses as well.

Different types of mortgages are available. Although most mortgages have the same basic requirements, the type of mortgage you choose will determine the specific requirements you need to meet.

There are two main categories of mortgages: conventional loans and government-backed loans. Conventional loans are loans issued directly by a lender without any backing from a government agency. Government-backed mortgages are insured or guaranteed by government agencies, allowing lenders to issue loans based on criteria that is different than conventional loans since the government is insuring a portion of the loan.

Mortgage qualification basics

To qualify for your first home loan, you’ll need to meet several requirements. Don't worry if you can't meet all of them right away. There are steps you can take to improve your financial position and prepare for your first mortgage. Let's discuss the typical requirements you’ll need to meet in order to get a home loan.

Income

Lenders want to know you have a reliable stream of income that will allow you to make your mortgage payments on time. For this reason, your lender will need to verify the amount of income you bring in on a monthly basis, as well as its source or sources.

Sources of income that may be used to qualify for your home loan include:

• Wages from employment
• Self-employment income
• Business income
• Child support
• Spousal support
• Investment income

Reserves

Lenders realize financial hardships occur sometimes. Because of that, they want assurance that you have reserves, or liquid assets, available to cover your mortgage payments if you lose your regular source of income or face other financial problems. Assets you can put toward your reserves include:

• Checking account balances
• Savings account balances
• Mutual funds
• Stocks or bonds
• Retirement accounts
• Certificates of deposit

In most cases, your lender will want to see that you have enough assets to cover two or more months of mortgage payments in the event of an emergency. 

Debt-to-income ratio

Your lender will need to make sure you have enough income not only to cover your mortgage, but also to pay your other revolving debts and monthly expenses. To ensure that, your lender will calculate a debt-to-income (DTI) ratio, which is the ratio of your mortgage and other monthly debts to your monthly income.

Lenders determine both a front-end debt-to-income ratio and a back-end debt-to-income ratio. The front-end DTI ratio is calculated by dividing your potential housing expenses — which may include your future mortgage payment, mortgage insurance, property taxes and homeowners insurance — by your gross income. Whereas the back-end DTI ratio includes all required minimum monthly debt payments found on your credit report.

To calculate your front-end DTI ratio, simply divide your expected monthly mortgage payment by your gross monthly income. To calculate your back-end DTI ratio, divide the total of your expected mortgage payment and other monthly debts by your gross monthly income.

Many lenders have limits for both the front-end and back-end DTI ratios. For example, a front-end DTI ratio of 35% and a back-end DTI ratio of 45% is considered desirable. Larger DTI ratios may be approved, but you may end up paying a higher interest rate. It’s rare for a back-end DTI ratio of 50% to be approved.

Credit

All mortgage lenders will look at your credit report and credit score. Your credit report provides information about your current debts and credit history. It shows the balances of all of your open accounts, as well as your payment history for each account. If you’ve filed for bankruptcy in the past few years, or if you have accounts in collections, this information appears as well.

Your credit score is a three-digit number that indicates your level of risk as a borrower. The higher your score, the more confident your lender will be in your ability to repay your loan without any problems. If your score is low, you may not qualify for the loan, or you may be forced to pay a higher interest rate.

In general, you can qualify for a home loan under most programs as long as your credit score is at least 620. If your credit score is lower than 620, you may still be able to qualify for a government-backed Federal Housing Administration (FHA) loan, especially if you can make a large down payment.

Down payment

In many cases, you’ll be required to make a down payment when you purchase a home. Ideally, lenders like to have a down payment equal to 20% of the purchase price. There are zero-down and low-down payment loan options available, however.

If you’re making a smaller down payment, you'll likely be required to pay private mortgage insurance (PMI), which will increase your monthly mortgage payment. Mortgage insurance is designed to protect the lender if you stop making your loan payments for some reason.

Improving your chances to qualify for a home loan

If you’re concerned you won't be able to qualify for a mortgage, don't despair. Whatever the issue may be, you can take steps to improve your profile as a borrower. Even if you already meet the basic mortgage qualification requirements, you may still decide to take some actions to increase your chances of getting the best interest rate possible. Here are a couple of tips to help you strengthen your mortgage application and get the loan you need. 

Boost your credit score.

If your current credit score is too low to qualify for a mortgage (lower than 620), or if you want to improve your credit score to lower your interest rate, you can work on making positive changes to your credit report.

For example, if you have credit card debt, paying down some of your balances can raise your credit score. Reducing the balance you carry month to month lowers your credit utilization rate, which is the ratio of your outstanding balances to your available credit. Ideally, this amount should be no higher than 30%.

You can also raise your credit score by making sure you always make your payments on time. A single late payment can have a significant impact on your score, so be careful to pay every bill by its due date. Keep in mind late payments are not reported to the credit bureaus until 30 days have passed, but it’s still best to pay your bills on time to be safe and avoid late fees.

Reduce your debt-to-income ratio.

Your debt-to-income ratio can make or break your ability to qualify for a home loan. Even if you do qualify, a high DTI ratio may cause you to miss out on the lowest mortgage rates, which will raise your monthly payment. Not only that, but a high DTI ratio indicates you may have trouble making your mortgage payments with your current financial situation. If possible, take steps to lower a high DTI ratio before attempting to buy a home.

In order to improve your DTI ratio, you must either increase your income or decrease your debts. For most people, lowering revolving monthly debts is a more realistic strategy. You can do that by paying down your balances and eliminating new spending. You may also be able to lower your monthly debts by refinancing installment loans, such as car loans or private student loans.

Down payment considerations

Many borrowers are tempted to seek out a lender or loan program that allows them to qualify for the loan by putting down as little money as possible. If, instead, you choose to make a larger down payment, you’ll gain several advantages. Specifically, a larger down payment could:

• Lower your interest rate by making your loan less of a risk.
• Help you avoid paying private mortgage insurance.
• Decrease your monthly payment by reducing the loan's outstanding balance.

Although it may take some time to save up for a 20% down payment, the benefits that come with a larger down payment are worth the effort. When you consider the money you could save on both principal and interest each month, as well as the potential to eliminate the need for private mortgage insurance, you could be looking at hundreds or even thousands of dollars saved per year.

Fortunately, there are several strategies you can use to put money away for an eventual down payment. Let’s look at three of them:

1. Find money in your budget.

The best place to start is by combing through the details of your monthly budget to look for any opportunities to reduce your spending. Take the money you save through these budget changes and put it into your savings account.

2. Sell unwanted items.

Most people have at least a few things lying around that are no longer used or needed. If you have any valuable items you don't want anymore, consider selling them on eBay or a similar platform. When you sell an item, put the money into savings so you won't be tempted to spend it.

3. Pick up a side job.

In today's world, finding an extra stream of income is easier than ever before. Consider delivering food, joining a ride-sharing company or selling something homemade. As with any savings strategy, it’s best to put the money you earn directly into a separate account so it will be earmarked for your down payment.

The importance of a home loan conditional approval

As you can see, qualifying for a mortgage can be complicated. For some borrowers, getting a mortgage may even require some lifestyle changes and patience. Because not every borrower will be able to qualify for a mortgage on the first try, it’s a good idea to get a conditional approval for a home loan before you start house shopping.

Although it's not a guarantee that you’ll qualify for the loan, a conditional approval gives you a good idea of how much you can afford to borrow. Buyers with conditional approvals also tend to be more attractive to sellers, giving any offers you make an extra advantage.