Many Americans want to buy a home, which involves getting a mortgage for most of us. A potential obstacle to being a homeowner, however, is having too much debt. When you have a lot of debt on credit cards, car loans, and student loans, it raises your debt-to-income (DTI) percentage, which can make it more difficult to be approved for a loan.
Eliminating Revolving Debt Can Help You Get Approved for a Great Mortgage Loan
That’s why many potential homeowners try to clear debt from their credit report before applying for a mortgage. Keep reading to learn about when and how clearing debt can help you with the mortgage process. If you are ready to apply, our loan consultants are available to lay out your best mortgage options.
Credit Card Debt On The Rise
Experian reports that average credit card debt in the US was $5,900 in 2022. If you want to get a mortgage and have a lot of credit card debt, this can be a problem. Having a lot of debt means much of your available credit is being used, which will lower your credit score.
Or, you could be approved for a home loan with a lot of previous debt, but your rate will be higher. This could make a big difference in your finances. The typical home in the US cost $370,000 at the end of 2022. If you are approved with a 6.5% rate because of your higher debt load, remember that you might have qualified for a lower rate if you had no other debt.
How Much Does Debt Affect Your Credit Score When Buying A Home?
If you have thousands in credit card debt but have been making timely payments, paying off your debt could raise your credit score dramatically. Paying off debt means increasing your available credit, which the credit agencies say makes you a better risk. Mortgage lenders will notice that you have more income available for mortgage payments and home repairs. So, paying off debt will raise your score considerably in the short term, and that could make your mortgage application more appealing to the lender.
If you have a decent credit score above 670, you may be able to apply for a conventional mortgage. You could probably buy a point to reduce the interest rate from, for example, 7% to 6%. Over the years, this could be a good investment.
You also could hold the home loan for a few years, let your equity increase, and refinance the home at a lower rate. However, rates have been high and it’s unclear when they will drop substantially, so this could be a risk.
How Credit Card Debt Affects Your Mortgage Application
Having credit card debt will not automatically stop you from getting a mortgage; mortgage companies expect you to have debt. But it needs to be manageable debt that will not affect your ability to pay your mortgage. When your DTI is too high, the lender may decide you are too much of a risk and will deny the home loan. They also could approve you but for a lower amount than you want. This could put your ‘dream home’ out of reach for now.
There are two DTI ratios that lenders will check that could be affected by too much debt:
• Front-end DTI that divides the monthly housing payment by your monthly gross income. You usually want to be at 28% or lower to be approved.
• The back-end DTI takes the total debt payment per month and divides it by your gross monthly income. This should be 36% or lower.
Mortgage companies usually see the back-end ratio as the most important. The back-end ratio gives a full picture of the ability to make a mortgage payment. If your back-end DTI is above 36%, it is more difficult to qualify for the loan. The lender might not consider any installment loan that is almost paid off for calculating your DTI.
Generally, if you clear debt from your record, it will cause your credit utilization and DTI ratios to drop quickly. This will usually be represented on the following month’s credit report. If you can manage to clear debt before applying for your home loan, it could improve your chances of being approved and getting the lowest rate.
Many second mortgage loans will help you consolidate debt and the underwriter will consider this when reviewing your loa application. These types of debt consolidation loans will lower your debt to income ratio immediately because they eliminate the revolving debt.
How to Clear or Reduce Debt Before Getting a Mortgage
There are several ways to pay down or pay off debt before applying for a mortgage outlined below. If you have substantial debt, have your credit report reviewed a mortgage professional before applying for the loan. They can give you an idea how much your debt will affect your ability to qualify and the potential interest rate.
Roll Debt Into a Zero Interest Credit Card
If your credit is good, you may qualify for a zero interest credit card for 12 or 18 months. You will still have debt, but it will reduce the payment, which improves your DTIs.
Roll Debt Into a Personal Loan
If you have credit card debt, you could save interest by rolling debt into a lower-interest personal loan. This also diversifies your debt mix, which could aid your score.
If you want to clear debt and don’t have enough savings, a possible solution is to borrow from a retirement account. Yes, you may have to pay a penalty for an early withdrawal, but this could get you into your home at a good rate. Then, pay the money back as soon as possible. However, you should talk to your financial planner if this is a good move in your case.
Takeaway on the Benefits of Being Debt-Free Prior to Applying for a Mortgage
Clearing debt will potentially make it easier to be approved for a home loan at a lower rate. Speak to one of our loan professionals to learn how much debt you should clear or if it is necessary to obtain a mortgage in your situation.
