Ready to buy your own home? There’s a lot to consider, especially if this is your first time applying for a mortgage and you’re carrying debt. Debt is not necessarily a dealbreaker by any means.
Is it a good idea to pay off debt or save for a house? Is it possible to do both? Understanding how the home loan process works could help you make those decisions and avoid mistakes that could keep you from getting your dream home. When a lender considers you for a mortgage, you can expect debt to be a factor when it comes to how much you’ll be able to borrow, the interest rate you might pay and other terms of the loan.
Related: 7 simple ways to reduce a mortgage payment
1. How to Manage Debt before Buying a Home
Understand Your Debt-to-Income Ratio
When lenders want to be sure borrowers can responsibly manage a mortgage payment along with the debt they’re carrying, they typically use a formula called the debt-to-income ratio (DTI). The DTI ratio is calculated by dividing a borrower’s recurring monthly debt payments (future mortgage, credit cards, student loans, car loans, etc.) by gross monthly income. The lower the DTI, the less risky borrowers may appear to lenders, who traditionally have hoped to see that all debts combined do not exceed 43% of gross earnings.
Here’s an example:
Let’s say a couple pays $600 combined each month for their auto loans, $240 for a student loan and $200 toward credit card debt, and they want to have a $2,000 mortgage payment. If their combined gross monthly income is $8,000, their DTI ratio would be 38% ($3,040 is 38% of $8,000).
The couple in our example is on track to get their loan. But if they wanted to qualify for a higher loan amount, they might decide to reduce their credit card balances before applying.
That 43% threshold isn’t set in stone. Some mortgage lenders will have their own preferred number, and some may make exceptions based on individual circumstances. Still, it can be helpful to know where you stand before you start the homebuying process.
Consider How Debt Affects Your Credit Score
A mediocre credit score doesn’t necessarily mean you won’t be able to get a mortgage. Lenders also look at employment history, income and other factors when making their decisions. But your credit score and the information on your credit reports likely will play a significant role in determining whether you’ll qualify for the mortgage you want and the interest rate you want to pay.
Typically, a FICO Score of 620 will be enough to get a conventional …….