Most people who want to be homeowners take out mortgages from lenders. However, having debts may affect the loan approval, loan amount, interest rate, and other loan terms. Many lenders do not entertain borrowers with existing debt loads. As a result, they might disapprove of many loan applications. So, you might want to know how your past credit and current debts can affect your potential lenders. You also need to know how you can improve your chances of buying a house with a debt burden.
Yes, you may buy a home if you have debts. But it will be much easier to be a homeowner if you don’t have any debt burden. Your credit history and monthly debt payments will play a significant role when you want to buy a house and apply for a mortgage. Mortgage lenders will verify your DTI (debt to income) ratio, which is how much debt you have compared to your gross monthly income. They will verify whether or not you can afford to make the monthly payment on a mortgage loan.
A mortgage lender usually prefers a borrower with a debt-to-income ratio of 43% or less. Any applicant with more than that may face rejection. It’s possible that your mortgage terms will be strict if your DTI ratio is close to that percentage.
To calculate DTI, add up all of your monthly debt payments, such as:
- Student loan payments.
- Car loan payments
- Credit card payments
- Payday loan payments
- Personal loan payments
- Alimony or child support
Then, divide that number by your gross monthly income. Your gross monthly income is the total amount of money you make before taxes, including any health care reductions.
- Medical bills or debt
- Mobile phone bills
- Utility bills
Your mortgage interest rate will be cheaper if you have good credit. Lenders usually prefer a FICO® credit score of at least 620 to approve a mortgage application. However, some mortgage lenders also look at applications with credit scores of at least 580. But, they will charge a higher interest rate and a big down payment. So, raising your credit score before applying for a mortgage is good. Paying off debts will be the most effective way to grow your score.
Your FICO credit score is made up of five different categories:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit: 10%
- Credit mix: 10%
High-interest debts such as payday loans or credit card debt are listed under the “amounts owed” category. The more debt you add, it’ll increase the credit utilization ratio. The credit utilization ratio measures how much available credit you currently use.
So, the more debt you owe, it’ll be recorded into your credit report, eventually negatively affecting your credit score.
So basically, having huge existing debt may indicate:
- Your DTI is high, and you can’t handle your monthly mortgage payment.
- Your high credit score pushes lenders to offer high-interest rates and strict terms.
- Makes you unapproved for some home loan programs with attractive offers.
Getting your DTI ratio down can be done in a number of ways:
The less debt you have, the less you will have to pay each month. So, you should try to pay off your debts in full every time. It will also boost your credit score. If you can’t pay off the entire debt amount of a high-interest debt such as credit card balances, you can consolidate the debt using DIY methods or get help from a debt relief company. You can also settle your debts through a debt settlement method, but it may harm your credit score.
Including someone else on the loan as a co-signer may help you to be approved easily. You will owe less on the loan if you have a co-signer.
You can make more money each month if you have a side job or a business you run from home.
When you buy a house, paying more upfront means you borrow less. If you borrow less, a mortgage lender might offer better terms.
There are certain moves you can make to improve your credit report and boost your score before buying a house or applying for a mortgage. Here are some ways:
Paying off high-interest debts like credit card debt or payday loans can boost your score. If you have multiple accounts with outstanding credit card balances, you can consolidate those accounts with a debt consolidation loan and make one payment monthly. Similarly, using a payday loan consolidation option, you may get rid of annoying payday loans. This way, you can pay off each credit card balance you have and reduce your overall interest payment.
You may also try to get rid of your unsecured debt by:
Figure out how much you can afford to pay each month toward your debt payments. Pay more than the minimum amount if possible. This will speed up your debt payoff process.
List your outstanding debts and start with the minimum credit card balance account. Pay as much as possible towards that account. This way, you can pay off that account soon. Once it is done, select the next account with the lowest balance. This is called the “debt snowball” method.
You can also follow the same pattern and start paying off the accounts with the highest interest rate. This process might take longer to pay off all the unpaid debt accounts. However, you can reduce the overall interest payment in the long term. This is called the “debt avalanche” method.
You may find multiple apps like Tally† that can help you pay off your credit cards faster.
Set up a realistic household budget to help you manage all necessary expenses and monthly payments. A solid budget plan can help you save money, lower your credit utilization ratio, and pay for necessary payments like groceries, power bills, medical costs, rent payments, etc. The more you can save, the more you may invest that money to get out of debt. It will also stop increasing debts through new credit card balances. Try to pay off new credit card debts entirely within due dates.
Get a free copy of your credit report and analyze every item listed there. If you find any error, dispute it ASAP. You’ll have to request your report from each credit bureau.
- Equifax – call 1-866-349-5191
- Experian – call 1-888-397-3742
- TransUnion – call 1-800-916-8800
Having huge debt payments could also create a shortage of cash, which might interrupt the home buying process or mortgage. You need cash for the following:
No matter how much you want to contribute as a down payment, you’ll need to have that money ready when you decide to buy a house with a mortgage.
You might have to put 3% to 6% of the full loan amount as closing cost, which is not a small amount.
Moving across town can cost hundreds or even thousands of dollars, so you should also include the cost of moving in your home buying costs. If you’re moving for work, your office may contribute a part of that cost. However, you might need to pay all the costs upfront.
The best mortgage offers always depend on the borrowers’ Debt-to-income ratio. For example:
- FHA loans are normally offered at a Debt-to-income ratio of 45% or lower.
- USDA loans are offered at a Debt-to-income ratio of 43% or lower.
- Conventional mortgage loans require a Debt-to-income ratio of 45% or lower.
High-interest debt, such as a payday loan or credit card debt, affects the mortgage lender’s approval criteria. Lenders will always require at least 20% of the home value as a down payment.
However, there are many loan programs that require smaller down payments. The Federal Housing Administration provides FHA loans, which usually need a 3.5% down payment. The U.S. Department of Veterans Affairs (VA) or the Department of Agriculture (USDA) loans with no down payment to qualified borrowers.
A homebuyer can get a conventional loan with just 5% down, but this normally comes with a few catches:
- When you put down a small down payment, your monthly mortgage payments will be higher.
- In closing, if you pay less on the total price, you may need to borrow more money as a mortgage. This means you will pay more interest in every monthly payment.
- If you put less than 20% down on a new home, you may need to buy private mortgage insurance (PMI). So, you’ll pay PMI, property taxes, and homeowner’s insurance.
It is better to get rid of your debts before you buy a house. Lenders can check your affordability, DTI, and credit score. Lenders don’t appreciate it if you have too many high-interest debts like credit card debts or payday loans. You might have a better chance of getting a mortgage if you take steps to lower your DTI, improve your credit score, and arrange a bigger down payment. This way, you can get a better offer for your homebuying process, such as a lower mortgage rate and affordable monthly mortgage payment, without paying for the PMI.
Attorney Loretta Kilday has over 36 years of litigation and transactional experience, specializing in business, collection, and family law. She frequently writes on various financial and legal matters. She is a graduate of DePaul University with a Juris Doctor degree and a spokesperson for Debt Consolidation Care (DebtCC) online debt relief forum. Please connect with her on LinkedIn for further information.