Answer: Before you go house-hunting, the first step is to get pre-qualified so you’ll know in what price range you can shop. It is not unusual for first-time buyers to be somewhat baffled about how to estimate what mortgage payment they will be able to handle each month, as well as how much money they’ll need for a down payment and closing costs. That’s why it is a good idea to get pre-qualified through a lender before you start to look for a home. Pre-qualification determines exactly how much a lender is willing to loan you based on the standard mortgage lending guidelines of the industry. Todays mortgage lenders have many tools at their disposal to help you get the maximum home loan.

Until a few years ago, lenders use the established debt-to-income ratios of 28% and 36%. For instance, your proposed mortgage payment (principal, interest, taxes, and insurance or P.I.T.I.) could not exceed 28% of your gross monthly income. The 38% ratio applies to all of your long term debt (P.I.T.I. as well as any other long term debts you are carrying. i.e. car payments, school loans, revolving credit lines, etc.). The total of those monthly obligations should not exceed 36% of your gross monthly income. If you have multiple car payments, or large balances on credit card accounts, that will reduce the allowable loan amount dollar for dollar.

Many of you may be aware of the relatively new "FICO" score which now plays a significant role in the mortgage industry. Named for the Fair Issac Company, this score is an automated rating process that takes many credit aspects into account. The higher the FICO score, the better your credit rating. Some of the negative factors that can impact a FICO score include bankruptcies, delinquencies, late payment on accounts, collections, too many credit lines with maximum funds borrowed, too many credit inquiries (when you authorize someone to pull your credit report), and too little credit history.

The advantage of the FICO score is that it provides a relatively accurate picture of a borrowers credit worthiness. If your FICO score is 680 or above, you will likely be viewed as an A+ borrower and the above mentioned 28% and 36% ratios could be significantly relaxed. A score between 620 and 680 simply means the underwriters will take a closer look at the file in determining potential risks. A score below 620 might prohibit you from qualifying for the best rates and terms.

When a lender pre-qualifies, they are more concerned about the buyer’s credit worthiness than the price of the property. For this reason, lenders are interested in more than just a buyer’s income. They also want to know how much existing debt a buyer has, what their ongoing financial obligations are, and what the buyer’s monthly budget looks like. Pre-qualification does not obligate buyers to take the loan from the lender, nor should it involve any fees (until later, when actually applying for the loan).

An important factor that may influence a lender to authorize a loan with a higher debt-to-income ratio (where debt payments take a higher percentage of a buyer’s income) is a larger down payment. Buyers who put down a bigger downpayment are considered better risks because the theory is with more of a person’s assets at risk, the less likely they are to default on the loan.

Buyers usually discover that the pre-qualification process will produce a home purchase price that is roughly 2-to-3 times their gross annual income. The 2-to-3 guideline is only a general rule of thumb, however, and it doesn’t take a buyer’s full financial situation into consideration. Since the lender’s calculations will also consider a buyer’s actual debts and ongoing expenses, the loan pre-qualification amount may be higher or lower.

Pre-approval is the next step in the process. Although the terms are often erroneously interchanged, pre-approval differs from pre-qualification in that a buyer actually provides the necessary paperwork and financial documents that the lender will use to process the loan. A buyer can be pre-approved prior to finding a home. The advantage is that the buyer has a written loan commitment from a lender that requires only the appraisal of the chosen property to complete the transaction. This can be a significant advantage when negotiating with a seller. Many lenders will complete a pre-approval at no cost to you, only requiring the application fee ($295-$325) once a home is found. Pre-approval is quickly becoming the preferred method of homebuying since it eliminates significant questions about the buyers ability to purchase as well as weeks of processing time to approve the loan, both of which make a buyers offer more attractive to a seller.

Few of us are exempt from the financial ups and downs of life that affect our credit rating. Knowing the factors that impact your credit worthiness will better prepare you for the times when you need it.