ACID Test or Liquidity Ratio: How it Applies to Your Mortgage Approval
Buying a home can be both exciting and nerve-racking. If it’s your first time, you are probably overwhelmed. Before you buy a home, you’ll want to know the steps involved, money saving strategies, and the mistakes to avoid for first time home buyers.
One of the biggest reasons first time home buyers are unable to buy the home they want is because they are unable to qualify for a mortgage. You should spend equal time and effort on improving your mortgage qualifications as you do on finding a great home.
Before you begin the home buying process, you’ll want to learn about everything a mortgage lender and bank will want to see, in order for you to qualify for a home purchase.
The good news is you’re here, and you’re ready to learn the steps involved. Prepare yourself for an emotional roller coaster ride because the home buying process is full of ups and downs. Knowing how your mortgage will impact your home buying process will help.
Qualifying for a Mortgage as a First Time Home Buyer
Think ACID (Assets, Credit, Income, Debts)
Assets are one thing banks will take a close look at, specifically your liquid assets. They will want to know how much money you have tucked away for a down payment, closing costs, and making monthly mortgage payments as you move forward in buying a home.
Banks and lenders will want to see that not only do you have the assets necessary, that the assets you do have are ‘seasoned.’ The assets you have in your bank account will likely need to have been there for at least 60 days for a bank to consider them assets.
Down payment and closing costs add up. So do all the hidden fees you aren’t accounting for like inspectors, home repairs, furniture, etc. You’re probably thinking, as many first time home buyers do, ‘maybe my parents will help me?’ Stop and read this next paragraph carefully if you intend to borrow money to help buy a home:
Down Payment Gift Rules: The gift must be documented with a formal ‘gift letter’ and the paper trail must be shown for the gifted monies as they move from account to account. The gift cannot be a loan in disguise and can only be up to 6% of a home’s purchase price. If your purchase price is $200,000 the gifted money can not exceed $12,000. Talk to your mortgage lender or Realtor specifically about how this would work to abide by FHA, VA, USDA loan regulations. If you don’t receive the gift properly, the lender is likely to reject your home application.
Your current assets help to improve your net-worth, and it’s an indicator of your ability to pay back a loan. Your current assets minus your liabilities, give mortgage professionals an idea of where you are in terms of your financial health. If your liabilities greatly outweigh your assets then you may want to focus on paying down some of what you owe before buying a home.
Credit is an important part of the mortgage approval process. Credit history and scores play an important role in your qualifying for a mortgage, as well as receiving the best rates. You can check your credit scores online by visiting CreditKarma and creating a profile. You will also find advice on their site to help improve your score.
Credit history is the largest determining factor in your credit score. This is unfavorable to anyone who is looking to buy a home at a young age since they typically won’t have the same credit history as someone who is older. This doesn’t mean you won’t qualify for a mortgage, though! Credit history is just one important part of your credit score. There are other factors such as inquiries, on-time payments, etc.
Shoot for a score of over 700 to be a good candidate for most mortgage lenders. A lot of times a score of over 600 is doable. In the 500 range, you may want to seek advice from a credit repair expert as your first step.
Your lender is going to need to pull your credit. If you’re serious about buying a home this is an important step. If you go to the Doctor they will need to check your health, in the same way, a mortgage professional needs to check your financial health. A credit score is one indicator of your ability to pay back the loan.
Over 30 years, your interest rate is going to add up fast, so do everything you can to improve your score before taking a mortgage!
Your income will play an important factor in how much the bank will be willing to lend you. They will also want to look at your employment, income, and tax history to better determine how much money you are keeping. Keep in mind that your tax strategy remains an important part of buying a house as well.
Income is important because it is one of the two factors in your debt-to-income (DTI) ratio. Your debt-to-income ratio is a math equation mortgage professionals use to determine your eligibility for a loan. It is typical of banks to require a 36% debt-to-income ratio or less in order to approve you for a loan.
For example, if you pay $1800 a month for your mortgage, another $200 for an auto loan, and $500 a month for the rest of your debts, your monthly debt payments are $2500 ($1800 + $200 + $400 = $2500) If your gross monthly income is $7500, then your debt-to-income ratio is 33 percent.
Generally speaking, you will want to keep your debt-to-income ratio below 36%. The lower your debt to income ratio the more likely you are to receive the loan you are seeking. With interest rates as low as they are, it keeps your debts low.
Debt plays a big role in your ability to qualify for a mortgage. Your monthly recurring debts are likely going to be a part of your debt to income ratio. Certain debts may be excused from the equation. Typical monthly recurring debts are your car payment, student loans, credit cards, and business expenses.
In a lot of instances, your debt to income ratio will need to be below a certain number before a bank will give you a loan. They may even require you to pay off certain debts in order to qualify. Some of my clients have been able to qualify for a loan following a car pay off, or other large expense that may be keeping them above the debt to income ratio.
Even if you have the liquid assets necessary to pay cash for the home, a bank can still choose not to lend you the money based on your debt-to-income ratio. There are guidelines they must meet in order to lend you the money.
Debt-to-Income ratio plays a big role in the loan approval process. Buyers with a high DTI are less likely to get approved for a loan than buyers with a DTI.
Mortgage rates remain near all-time lows, which helps to hold DTI down.
This is the role the ACID Test (Liquidity Ratio) plays in your ability to qualify for a mortgage and buy a house. This same ratio that applies to buyers also applies to businesses and is known as the 'quick ratio.'
Hi there! I'm Ryan Fitzgerald, a REALTOR in Raleigh-Durham, NC and the owner of Raleigh Realty. Chances are you and I share a similar passion, Real Estate! I also have a passion for technology, sports, and people. Would love to hear from you. Drop me a note in the comments section below and feel free to share this article socially!