Credit cards, student loans, and other debts are a fact of modern life. Last year, the average American carried about $38,000 in personal debt. And fewer than one in four American adults are completely debt-free.
But if you think you’ve got to be completely free and clear of all other financial obligations before you can think about buying a home, think again. People with credit card bills and student loans become homeowners everyday. You don’t need to be completely debt-free to qualify for a mortgage. Would-be homeowners just need to be savvy about how other debts impact their chances of qualifying for a mortgage. (Hint: it’s all about the monthly budget.)
Your Debt-to-Income Ratio
Having debt doesn’t necessarily doesn’t mean your finances are in bad shape. Mortgage lenders evaluate potential borrowers based in part on their debt-to-income ratio, or DTI. The debt-to-income calculation is just what it sounds like. DTI is the percentage of your monthly income that you have to use to pay off your existing debt obligations.
So, let’s say you earn $4,000 a month. Your student loan payment is $450 a month. You’ve got a car payment that’s $200, and the monthly minimums on your credit cards add up to $350 a month.
$450 student loans + $200 car note + $350 credit cards = $1,000 in debt payments.
$1,000 in debt payments / $4,000 in income = a DTI ratio of 25%.
Generally, lenders want to work with borrowers who will be paying less than 43% of their income each month towards all of their debts once the mortgage is finalized.
(Worth noting: 43% DTI is pretty much the absolute maximum. If you’ve got lousy credit or basically no savings, lenders may insist that your DTI be lower.)
In this example case, your existing debts are already taking up 25% of your income. So, the maximum mortgage payment you could add on top and still come in under the 43% threshold would be about $720.
Now, whether that’s enough for a mortgage payment on a home you want to live in is going to depend on how much you can use as a down payment, and what housing prices are like in your part of the country.
But as your other debt obligations are paid off, the size of the mortgage you might otherwise qualify for goes up. So, in this example, paying off the $200 car note would mean and your potential mortgage amount could go up to $920 a month. Pay off all your debts, and you could qualify for a mortgage with a payment as large as $1,720 a month.
Don’t Stretch Yourself Too Thin
Remember, lenders calculate your DTI ratio based on your pre-tax income. Depending on your tax situation, 40% or more of your pre-tax income could be more than half of your take-home pay after taxes. That’s a lot.
Using more than half of your paycheck on housing doesn’t leave you much money to pay for groceries and utility bills and the occasional pair of new shoes. Just because you can get a mortgage that’ll take half your paycheck doesn’t mean you should.
That said, not all debt obligations are the same. Maybe you’ve only got six months left on your car note, or a year or two left on your student loans. In that case, a just-under-the-wire DTI ratio might make sense. Tightening your belt for a few months to get into the house of your dreams could be a reasonable move. Just be sure you do a financial reality check before signing on the dotted line.
Some Strategies to Lower Your Monthly Debt Obligations
DTI is only concerned with what you owe on your debts each month. So if a high DTI is coming between you and your dream of owning a home, you may be able to lower your DTI by working to lower the required monthly payments on your debts.
For credit card debt, a personal debt consolidation loan could lower your monthly payment. And a lower payment, in turn, could improve your DTI. As a bonus, many debt consolidation loans come with lower interest rates than credit cards. (Just be sure to read the fine print and seek out a reputable lender.)
If you’ve got student loans, check to see if you qualify for a repayment plan with a lower monthly bill.
Most student loan servicers offer extended or income-contingent repayment plans. Switching to a different repayment plan could lower the amount you’re obligated to pay each month and improve your DTI ratio. Consolidating student loans with a new servicer could also lower your monthly payment. Again, pay attention to the fine print. Extending the repayment term on your student loans will probably increase the overall amount you pay back. (You can always elect to pay more than the required minimum. Or, you could switch back to a more aggressive payment plan at a later date.)
Ready to get the ball rolling? Want to see where you stand? You could be pre-approved for a mortgage in just a few minutes. Get started here.