Buying a home and taking out a mortgage is a big investment, and not just for you.
When you choose a mortgage lender and get approved for your home loan, your lender agrees to lend you all the funds necessary to pay off your home purchase. Since a home is an expensive purchase, lenders want to make sure that you are not a “high risk borrower.” Lenders want to know that you can make your monthly payments on time and in full.
How do lenders decide if you are at risk?
In most cases, mortgage lenders or their insurers, to be precise, will take a look at how well you have managed debt in the past and how well you are currently managing debt.
So having debt can be good.
This may seem counter-intuitive because when you buy a home you want to save as much money as possible. And you probably wouldn’t want your money in any other debt, would you?
Yes, saving money is always a good idea. But having debt before buying your home can actually be an important factor in obtaining a mortgage.
Why Debt Matters
To see how well you are managing your debt, mortgage lenders will take a detailed look at your credit / credit history and debt-to-income ratio (DTI).
In general, you want to a high creditworthiness and a low DTI. A good credit score indicates that you are responsible with your debt. A low DTI indicates that you did not tie up too much of your income to pay off this debt.
Let’s take a closer look at both factors:
Every factor in your credit score is defined by debt. And in order to build and increase your credit score, you need to take on debt and manage it responsibly.
Your creditworthiness is usually influenced by the following five factors:
- Payment history – Your balance of payments is the most important factor that goes into your creditworthiness. Lenders want to know if you are a trustworthy borrower. And so, they want to see if you can make timely payments on other debts.
- Loan Drawings (or Amounts Due) – Having money on your credit cards in particular is not a bad thing. However, if you are using too much at once, underwriters may understand it to mean that you are financially overwhelmed.
- Length of credit history – A longer credit history is beneficial. But if your credit rating is limited, you will not necessarily be excluded from borrowing.
- Credit mix – Underwriters want to see how they manage different types of debt.
- New credit – Having multiple credit accounts open at the same time is a red flag for underwriters as it can indicate that you are in financial distress.
For a mortgage, you usually need it a credit score of at least 620 for a conventional loan. However, it might be best to shoot for a credit score of 700 or more. A higher credit score increases your chances of getting approval and also increases the loan amount that you will be approved for. But a good credit rating can also help you secure a lower mortgage rate, which can save you a significant amount of money over the life of your home loan.
Your Debt-To-Income Ratio (DTI)
Your DTI is a percentage of how much of your income will be used to pay off debt. Because a mortgage is such a large investment and your monthly payments can be quite high, insurers want to make sure you can make those payments. The lower your DTI, the better.
In general, a DTI of 36% or less is ideal. In fact, a DTI above 50% will most likely not be approved (although there are exceptions).
To calculate your DTI, simply divide your monthly debt by your gross monthly income. If your resulting percentage is greater than 50%, then you should work on paying off some of your debt.
Tips on debt management
Whether you’re looking to get your debt down before buying a home or just want to maintain solid creditworthiness through consistent loan payments, knowing how to manage your debt can help you qualify for a mortgage. And it can also reduce your own stress levels.
The following tips can help you manage your debt before buying a home, and they can also be helpful if you’ve bought your dream home and are making mortgage payments:
Look at your credit report
Your creditworthiness is an important factor in qualifying for a mortgage. So it can be a good idea to take a look at your credit report to make sure everything was reported correctly and that there are no errors. You don’t want your credit score to be adversely affected by errors in your credit report.
You can order your credit report from any of the three major credit reporting agencies: Equifax, Experian, and TransUnion through annualcreditreport.com. Or, you can get your free credit reporting card here on Credit.com.
Once you have your credit report, it is important to note the following:
- Your personal information
- Your credit accounts
- Credit inquiries
If you find errors or inconsistencies anywhere in your credit report, you can appeal them to the credit reporting agency that prepared the credit report.
Consolidate Your Debt
If you find yourself making payments for different loans and / or credit accounts, pooling your debts in one account can save you money (and save you from stress). This way you only pay interest on one debt instead of several. Hence, there is no need to keep track of multiple payments.
Related read: What is a Debt Consolidation Loan and How Can You Get One?
Don’t make drastic changes to your balance
It can be tempting to pay off debts right before applying for a mortgage. However, this could affect your creditworthiness. When you pay off a debt, your credit score temporarily drops.
On the other hand, if you try to build up credit and open multiple credit cards or take on other debts before applying for a loan, it will also affect your credit score. Not to mention, seeing lots of changes and new debt before applying for a mortgage is a red flag for underwriters. This can indicate that you may not be financially ready to take out a mortgage.
Make a budget
Whenever there is a financial discussion, budgets need to come up. While the concept of creating a budget may seem obvious and excessive, it is a great way to keep track of your expenses and make sure that you are meeting all of your financial expectations and needs. There are many costs involved in buying a house. So you should make sure you can afford them.
In this case, creating a budget can help you show your current debts and other expenses in relation to your income. This way you can see what is happening and adjust if necessary. Having a budget gives you the peace of mind that you are not spending too much and still being able to meet all of your other financial obligations.
Build your emergency fund
Building your emergency fund before you take out a mortgage can be one of the most important things you can do. You never know what the cost of buying your home is, and you don’t want all of your money to be tied up on your mortgage and other monthly payments if, for example, your roof needs repairs or you have water damage.
It is often recommended that three to six months’ worth of expenses be set aside in an emergency fund.
The bottom line
Buying a home is a big investment, and it can be daunting to think about a mortgage when trying to pay off student loans, a car loan, credit cards, etc. To save money and save you from the stress and strain of paying off other debts so you can be sure that you can make the mortgage payments and enjoy your new home.
However, you don’t have to be debt free to buy a home. In fact, well-managed debt can improve your credit score and show mortgage lenders that you are a responsible borrower.
That doesn’t mean you have to dig yourself into a debt hole that you will never crawl out of again. By taking the time to budget or analyze your credit report, you can see how you are financially and where changes can be made. Perhaps you could consolidate some of your existing debt or pay off some of your debt in full.
In the end, you just want to make sure that you are comfortable and can afford to take out a mortgage.
The How To Manage Your Debt Before You Buy A Home post first appeared on Credit.com.