In the wake of several high-profile bank failures, Federal Reserve officials warn that consumers are likely to face tighter credit conditions when applying for loans, including mortgages. Put simply, a credit crunch means that banks and lenders will tighten their balance sheets by originating fewer loans, making it more difficult for some borrowers to qualify for a mortgage.
“Mortgage credit availability declined in April to the lowest level since January 2013, reflecting the tightening in broader credit conditions stemming from recent banking sector challenges and an uncertain economic outlook,” says Joel Kan, vice president and economist at the Mortgage Bankers Association, in a May 9 statement.
Here’s what you need to know about getting a mortgage in a credit crunch, and how you can prepare your finances if you plan on buying a home this year.
[Read: Best Mortgage Lenders.]
What Will Credit Tightening Mean for Homebuyers?
With stricter lending standards, some homebuyers may see higher mortgage rates, while others may not qualify at all. For many homebuyers, a credit crunch could just mean that it’s necessary to shop around with more lenders or consider different types of mortgage loans.
“Credit tightening can come in many forms,” says Mark Fleming, chief economist at First American, in a recent report. “For example, the availability of mortgages or other loan products may fall, or it may become more difficult to qualify for a mortgage because of lender requirements for higher credit scores, lower debt-to-income ratios, or larger down payments or greater cash reserves.”
For the majority of homebuyers who are seeking a conforming conventional or government-backed loan, such as an FHA loan, credit tightening won’t be particularly impactful. These types of mortgages are quickly moved off bank balance sheets into mortgage-backed securities. Plus, the eligibility requirements for such loans are set by the backing government agencies, not the banks themselves.
On the other hand, non-conforming loans like jumbo loans are held on bank balance sheets, making them more susceptible to changes in credit conditions. So for borrowers buying higher-priced homes who need a jumbo mortgage, qualifying for one may become more difficult.
Kan says that lenders are “not as willing to do jumbo loans anymore given the liquidity situation we’ve seen around the banking turmoil.” That will result in stricter credit requirements and higher mortgage rates.
The margin between jumbo loan rates and conforming loan rates has narrowed meaningfully over the past year, Kan says. Mortgage rates for jumbo loans have begun to increase in recent weeks, while rates for other home loans have declined or stayed about the same.
“The divergence in rates suggests that banks may be tightening credit in response to banking uncertainty for those products,” Fleming says. “By tightening credit and limiting the number of jumbo loans they originate, banks can reduce their exposure to credit risk and conserve their cash if needed.”
Still, a credit crunch isn’t likely to be the biggest problem facing homebuyers this year. Fleming says “it’s unlikely that the recent banking crisis will materially impact residential mortgage availability.” Instead, the more pressing issues for the housing market continue to be lack of affordability and inventory of homes for sale. Rising mortgage rates have driven up monthly housing payments and kept potential sellers on the sidelines.
“Even with high mortgage rates and reduced credit availability, the lack of for-sale inventory continues to be the biggest hurdle to more home purchase growth this year,” says Kan.
Looking forward, there’s the potential that lenders may continue to tighten their belts further due to recessionary pressures.
“Either way, when you do get a broader economic or market event like that, there is a typical tightening in standards as lenders try to decrease their risk,” Kan adds.
All the more reason for this year’s prospective homebuyers to begin planning ahead of time if they need to borrow a mortgage.
Tips for Getting a Mortgage in a Credit Crunch
During a credit crunch, banks tighten their lending standards for some types of mortgage loans. You may need to take some steps to make yourself a stronger applicant, especially if you plan on borrowing a non-conforming jumbo loan this year. Here are a few ways to prepare your finances for buying a home in a credit crunch.
Work on Building Your Credit Score Early
It’s always wise to work on building your credit score before applying for a mortgage, but it’s even more important in times of tight credit conditions. You can check your credit score through many banking and budgeting apps to see where you currently stand. You should also pull a copy of your credit report through all three credit bureaus — Equifax, Experian and TransUnion — on AnnualCreditReport.com. Doing so is free and won’t hurt your credit score.
Depending on your circumstances, you may be able to increase your credit score using the following methods:
— Dispute any errors on your credit report. You can also check your credit report to find areas for improvement, like paying off long-forgotten medical bills that have gone to collections.
— Continue making on-time payments. In the months leading up to your mortgage application, it’s important to stay current on your accounts. Set up automatic payments or payment due date alerts to avoid forgetting a bill.
— Pay down credit card debt. Work on lowering your credit utilization ratio, which is the amount of credit card debt you have compared to the credit limit on your account.
— Avoid opening new accounts before you apply for a mortgage. Applying for new lines of credit requires a hard inquiry, and it can also lower the average age of credit.
— Keep old, well-established accounts open. If you have an unused credit card, you could use it for a small purchase and pay the balance immediately to avoid the bank closing the account.
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Improve Your Debt-to-Income Ratio
Lenders consider your debt-to-income, or DTI, ratio when deciding whether you qualify for a mortgage. To calculate your DTI ratio, simply divide your monthly debt payments by your gross monthly income. You should aim to have a DTI ratio of 35% or less to increase your chances of being approved for a mortgage, although some lenders may accept a DTI ratio of 40% or higher.
One way to improve your DTI ratio is to pay off existing debts, such as a credit card or auto loan. You should also let your mortgage lender know if you pay off your credit cards in full each month, so you don’t get penalized for carrying a balance. They may ask to see a few months’ worth of bank statements during the underwriting process to confirm that you don’t carry revolving credit card debt.
Another way to lower your DTI ratio is to increase your income. But you don’t necessarily need to change jobs or take on a second job in order to boost your earnings. For example, you may be able to negotiate a raise at your current job. However, keep in mind that you may need sufficient documentation from your employer to confirm your new salary to the mortgage lender.
Save Up More Money for a Down Payment
Lenders may be more willing to originate mortgages with a lower loan-to-value ratio, which is the loan amount divided by the property’s value. The more money you put down on a home, the lower your LTV will be. A higher down payment can help you qualify for better loan terms, like a more competitive mortgage rate, and it could also help you avoid paying mortgage insurance premiums.
[Read: How to Get a Mortgage With No Down Payment. ]
Shop Around to Expand Your Options
Just because your mortgage application has been denied through one lender doesn’t mean you’re out of options. Apply through different types of lenders, like traditional banks, online lenders and credit unions, to find the right fit for your needs.
“Yes, loans are still available for those who need them, but it makes shopping around a little more of a challenge,” Kan says. “People might have to do a little more research and talk to a few more lenders to find the product that fits them.”
Also consider different types of loans, including conventional loans and government-backed loans from the Federal Housing Administration, the Department of Veterans Affairs and the U.S. Department of Agriculture. If you’re a veteran and you need a jumbo loan, you can consider a VA jumbo loan.
Keep Your Purchase Price Within the Conforming Loan Limit
It may be more difficult to qualify for a jumbo loan in a credit crunch. If you’re unable to secure the funding needed by getting a jumbo loan, you could consider lowering your purchase price to find a loan within the conforming loan limit. Conforming conventional and government-backed loans are less impacted when banks tighten their credit.
The conforming loan limit for most single-unit properties in the U.S. is $726,200 in 2023. In areas with a high cost of living, the CLL is up to $1,089,300. You can use this interactive map from the Federal Housing Finance Agency to view the conforming loan limits where you’re shopping for a home.
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How to Qualify for a Mortgage in a Credit Crunch originally appeared on usnews.com
