While it is possible to get a mortgage when in debt, home shoppers should be aware of the impact it has on the mortgage process.
Prospective buyers are sometimes surprised to discover that their debt load could lead to a higher interest rate, lower loan amount or the need to come up with a larger down payment.
To improve the chances of securing financing and having a smooth homebuying experience, buyers and real estate professionals should both have an understanding of the role debt plays when applying for a mortgage.
What real estate agents should know
Educating your clients about the impact their debt can have on their mortgage approval ahead of time will give them a chance to take preemptive steps, if needed, and increase the likelihood of a successful sale.
Make sure your clients know all the factors that come into play during the mortgage process.
Credit history. Lenders will look at a borrower’s credit reports from each of the three major credit bureaus — Equifax, Experian and TransUnion — to review their current debt obligations and payment history.
Credit score. A borrower’s credit score, which is based on the information in their credit reports, reflects the risk involved in lending to them. There are multiple credit scoring models, but most mortgage lenders will pull a buyer’s FICO score from each of the three credit bureaus and typically use the middle score.
Debt-to-income (DTI) ratio. A consumer’s DTI ratio gives lenders an idea of how manageable their debt load is in comparison to their income. To calculate, lenders divide the sum of a borrower’s monthly debt payments by their gross monthly income.
For example, if a buyer’s monthly obligations include a $300 car payment, $350 in student loans and $150 in credit card payments, and the prospective mortgage payment is $1,500, then their monthly debt payments equal $2,300 ($300 + $350 + $150 + $1,500 = $2,300). If their monthly gross income is $5,500, their DTI ratio is 42% ($2,300 / $5,500 = 42%)
Lenders typically want to see a DTI of 43% or lower, although some lenders may approve homebuyers with a higher DTI.
Down payment. Borrowers must meet the down payment requirements for their particular loan.
Other financial details. Mortgage lenders look at a borrower’s overall financial picture, including their employment history, their savings and their total assets.
What to do if you’re a client with debt
In addition to educating yourself on the factors that go into the lending decision, there are a few things you can do to increase your chances of approval.
Check your credit reports. Make sure your credit reports are accurate and dispute any incorrect items. You can get a free copy of your report from each of the three credit bureaus at annualcreditreport.com.
Pay your current debt on time. Payment history accounts for 35% of your FICO Score, so one of the best things you can do is to make on-time payments on your existing debts. One missed payment can ding your score and position you as a lending risk to your bank or mortgage company.
Pay down your debt. The amount of debt you have makes up 30% of your FICO score. For credit card accounts, your utilization ratio, or the percentage of your available credit in use, plays a significant role in that part of your score. So if you’re able to pay down some debt without eating into your down payment, that would be a good idea. Getting your utilization ratio under 30% is ideal.
Consolidate your debt. If you don’t have available funds to put toward your debt, consider these strategies:
Consolidate with a personal loan. Personal loans have rates as low as 3.99% and consolidating may give you the opportunity to lower your monthly payment and DTI ratio. But be careful, as taking out new credit just before you apply for a mortgage could lower your credit score and hurt your chances of approval.
Transfer debt to a low- or zero-interest credit card. Similar to above, this move could improve your DTI ratio, but if it means opening a new credit card account, then that could have an adverse effect.
Consider delaying the purchase. If your debt load is unmanageable or likely to be an issue during the approval process, it may be best to push back buying a home and focus on paying down the debt or increasing your down payment.
How debt impacts the lending decision
If a borrower’s credit history, credit scores or DTI ratio fail to meet a lender’s requirements, it could have one of many implications.
Larger down payment. The lender may request a larger down payment. For example, FHA loan borrowers with a credit score of 580 and above only need to put 3.5% down, but those with a score between 500 and 579 are required to put 10% down.
Higher interest rate. A borrower may be approved at a higher interest rate, which means higher monthly payments and paying more over the life of the loan.
Lower loan amount. Lenders may approve a loan, but at a lesser amount than anticipated.
Denial. When considering all factors, a lender may decline a borrower’s request for financing if the complete application reflects a borrower is a risky lending prospect.
While having debt is not an automatic disqualifier when applying for a mortgage, it is an important factor in the lending decision. Consumers and real estate professionals should familiarize themselves with the role debt plays and discuss taking precautionary steps if necessary.