In most cases, individuals consider loans as an approach to financing the purchase of a home. This approach makes credit rating a substantial aspect and a determinant of worthiness to acquire a loan for the targeted asset. A credit score is the first thing that mortgage lenders consider in order to approve an individual for a home loan. Credit rating refers to an evaluation of the credit risk of a prospective mortgagor that is used by the lender to predict the debtor’s ability to pay back the debt. On the other hand, the debt-to-income ratio is a factor that is highly considered by mortgage lenders for a home loan. There exist several debt-to-income standards that are accepted especially for federal home loans. In general, the debt-to-income ratio is considered as the amount of an individual’s monthly bills divided by the money, he/she makes in a monthly period. Lenders consider the debt-to-income ratio so as to determine the likelihood of repaying the loan after being approved for one.
Credit rating and debt-to-income ratios are significant for the lenders because they provide a better risk assessment platform before availing home loans to the mortgagers ( Belsky, Herbert & Molinsky, 2014 ). For instance, the FICO score in the US is associated with the credit ratings of individuals. It is mostly employed by different home lending institutions to evaluate risk assessment needs. Mortgage debtors prefer loans as a way of financing their purchase of homes. In return, mortgage lenders integrate the credit scoring systems with their home selling process. The credit score determines an individual’s creditworthiness and eligibility to secure a loan for purchasing a home ( Belsky, Herbert & Molinsky, 2014 ). The system gives mortgage lenders an idea of how an individual is likely to repay the loan or other related bills. Therefore, the higher the credit score, the more an individual is likely to be approved for a loan. In other cases, when an individual’s credit rating is relatively low, they can be approved for a loan but they will have to pay higher interest rates ( Belsky, Herbert & Molinsky, 2014 ).
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FICO is a company in the United States that presents the most widely used score ranging from 300 to 850 ( Belsky, Herbert & Molinsky, 2014 ). According to the FICO scale, the higher the score, the better the credit rating. For instance, someone with a credit score of 660 can be approved for a 30-year home at 5.3% rates. If the credit score is 682, he could be approved at a 4.7% rate. That’s a difference of about $28,000 over the loan period ( Belsky, Herbert & Molinsky, 2014 ). Different factors are considered while calculating the credit score. The first consideration is an individual’s payment history. Then information obtained on the payment history gives information on whether you can make payments on time and the frequency of payment of the bills. The amount owing to loans and credits cards is also a factor that is put into consideration while calculating the credit rating.
Additionally, the length of the credit history obtained from the credit rating systems is also considered while financing the purchase of a home ( Belsky, Herbert & Molinsky, 2014 ). High balances owed to creditors lowers an individual’s credit rating hence reducing the chances of being financed. Mortgage lenders usually consider credit history in order for risk assessment. When an individual has no credit history, the chances of being financed for a mortgage purchase are minimal. The types of accounts owned by an individual also contribute towards credit rating. Lenders consider financing individuals who have a mix of accounts, such as, retail, Installment loans, and home loans. Recent credit activity is the last factor that is considered for credit rating. Opening lots of accounts in a short duration suggests that an individual is facing financial trouble hence can contribute towards lowering the credit score, which is necessary for financing the purchase of a home ( Belsky, Herbert & Molinsky, 2014 ).
Debt-to-income ratio as identified earlier is a determinant in the financing of the purchase of a home by mortgage lenders. This ratio surprises loan applicants through the calculation adopted for its qualification. Generally, lenders compute the ratio of an individual’s debt relative to his/her income. The standard ratio to qualify for a home loan is usually 43% ( Belsky, Herbert & Molinsky, 2014 ). If monthly debt payments exceed 43% of the income, the respective individual is unlikely to get loan approval.
Let’s consider the following example. Mr. Peter receives an annual income of $60,000 with a monthly total of $5,000. His annual debt total is $30,000 with a monthly total of $2,500 ( Belsky, Herbert & Molinsky, 2014 ). To obtain the debt-to-income ratio, we need to follow the following mathematical steps. The first step involves dividing the debt by the available income. So in this case, (30,000/60,000) that gives 0.5. Then multiplying by 100 to obtain the percentage we obtain, (0.5*100) = 50%. Therefore, in relation to the average percentage, 43% that qualifies loan approval for an individual, Mr. Peter would be considered for a home loan ( Belsky, Herbert & Molinsky, 2014 ).
In conclusion, Credit ratings and debt-to-income ratio are mainly considered by the lenders for risk assessment on the loans offered to the mortgagors. The two aspects are considered as accepted standards that support the decisions of a lender to offer a mortgage loan to a person. Therefore, through determining the eligibility of a mortgagor for loan approval, the credit rating and debt-to-income ratio are considered in financing the purchase of a home. Before, approving a loan for a mortgagor, the lender must consider the debtor’s credit score and other relevant information to determine whether an individual will pay the loan on time and keep track of the debtor’s credit history that is substantial in decision making based on the loan approval basis.
References
Belsky, E. S., Herbert, C. E., & Molinsky, J. H. (2014). Homeownership Built to Last: Balancing Access, Affordability, and Risk after the Housing Crisis . Washington, D.C: Brookings Institution Press.
