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Not all debt is “bad” debt. Many of us probably can’t buy a house or go to college without taking on some debt. But if you haven’t bought a house and would still like to, having a large amount of debt is not ideal. A large portion of a lender’s decision to approve your mortgage relies on determining whether or not you can afford to pay it back. If you’re saddled with debts, the monthly payments you already owe may make it difficult to meet a mortgage payment each month.
That said, it’s not impossible to buy a house if you’re in debt. If you’re ready to stop renting but you’re concerned about how much debt you can have when buying a house, read on, because we’ll help you figure out how to do it.
Do you need a mortgage?
In most cases, you will need a mortgage to buy a home. A mortgage is a loan that helps you finance your home purchase. It allows you to get the money you need to complete a home purchase in exchange for monthly payments with interest until you pay off the loan or sell the home.
Unless you have the liquid cash to buy a property outright or can generate enough profit from a previous home sale to finance your next home purchase, you will need a mortgage. (If you do have the cash available to buy a home outright, you don’t have to worry about your debt impacting a mortgage — so you can skip this article.)
What do lenders look at before approving a mortgage?
No two lenders will have the same requirements for approving a mortgage, so there’s no one right way to answer this question. It all comes down to risk and how likely you are to pay the mortgage back. Most lenders will look at three main criteria on your your mortgage application:
- Debt-to-income ratio (DTI)
- Credit score
These three criteria help a bank better understand your financial situation and determine an amount it feels comfortable loaning to you. If you’re able to make a larger down payment, the bank may loan you more money. If you have a higher credit score and have shown an ability to pay off your unsecured debt (credit card debt) every month, the bank may approve a larger mortgage.
That’s all logical, but the DTI ratio is where things get a little tricky.
How much debt can you have and still qualify for a mortgage?
Your DTI ratio is the percentage of your gross monthly income that’s dedicated to paying off debts. Perhaps more than any other metric, this is the most important number when it comes to getting approved for a mortgage.
According to Investopedia, lenders prefer to see a debt-to-income ratio smaller than 36%, and most will not approve your application if your DTI ratio is higher than 43%.
Your DTI ratio also may determine the best mortgage for you. For instance:
- FHA loans usually require a DTI ratio of 45% or less.
- USDA loans require a DTI ratio of 43% or less.
- Conventional home mortgages require a DTI ratio of 45% or less.
Before you start looking for a home or approaching lenders, you should calculate your DTI ratio.
Calculating your debt-to-income ratio
Calculating your DTI ratio is simple. Let’s run an example:
Let’s say you make $50,000 a year. Divide that number by 12 (because that’s how many months there are in a year) for a gross monthly income of about $4,166.
Add up your debts, including car payments, credit card payments, student loan payments, furniture financing payments — anything you pay every month to a financial institution. (If you already have a mortgage, include the entire mortgage payment, including property taxes and insurance payments.)
Say the sum total of those amounts is $1,800. Divide that by $4,166 for a DTI ratio of 43.2%. That’s the very high end of the spectrum that a bank might approve your mortgage, so you’d have a better chance of mortgage approval with a high credit score or enough liquid assets to make a larger down payment. Otherwise, it’s time to lower your DTI ratio.
How to lower your debt-to-income ratio
In the most basic terms, lowering your DTI ratio requires earning more income or lowering your debt. Easier said than done, right? There are a number of practical steps you can take to lower your DTI ratio, though.
1. Pay down (or off) your debt
Again, it may seem obvious but paying down your debt is the best way to improve your DTI ratio. Making an effort to pay down or off an individual debt may make your financial situation look more favorable to lenders.
There are a few strategies to do this. If you’re close to paying off your car or a student loan while looking to buy a home, prioritize paying those off a little early. You might incur penalties from the lender but if you’re in the home buying process, a few hundred dollars in fees is a worthwhile price to bring your DTI ratio down to a more palatable place.
Another strategy is to focus on paying off recurring debts like credit cards. Paying off your credit card debt every month and keeping that unsecured debt low may help your credit score and your DTI ratio, two important criteria for a mortgage approval. Also, the more you pay down your credit cards, the better your credit-utilization rate looks. This number shows how much of your available credit you’re using (e.g. $500 every month out of a $10,000 credit line) and lenders like when you have credit that you don’t need.
2. Add another person to the loan
If you have a lot of debt but a partner who you plan to live with doesn’t, you can lower your total household DTI ratio by adding them to the loan. Your mortgage lender will calculate your DTI ratio using both of your incomes and debts, which may land you somewhere below that magic 43% number.
If your partner’s DTI ratio is comparable or higher to yours, however, you may want to do the opposite. Removing them (or yourself) from the loan may improve your household DTI ratio.
3. Get a second source of income
Starting a side hustle or working a second job brings in more income without increasing debts. That will drive down your DTI ratio. From picking up consulting jobs to starting a home-based business, there is no shortage of interesting side hustles available these days.
4. Consolidate your debt
Consolidating all of your loans isn’t always possible, but it can be a good way to lessen your financial burden and start getting your DTI ratio under control.
What exactly does consolidating mean? Let’s say you have four credit card payments every month. When you consolidate, you make one payment each month rather than four different payments to individual lenders. Likewise with something like student loans, you may be able to consolidate multiple loan payments into one, especially if you have government loans.
After consolidation, your monthly payment may drop due to multiple interest rates converging into a single one, thereby bringing down your DTI ratio and improving your chances of getting a mortgage approval.
5. Make a bigger down payment
It’s a myth that you have to pay 20% of a home’s sale price as a down payment. FHA loans require only 3.5% down and many mortgage lenders today will ask for only 5% down on a conventional loan.
That said, the less you pay upfront, the higher your mortgage payment will be, and if your DTI ratio is already high, a lender may not approve a high mortgage payment. If you put more money down upfront, the monthly mortgage and interest payments come down, making the arrangement less risky for the lender. If you’re at the high end of an acceptable DTI ratio, paying more upfront may make up the difference.
Before starting the home-buying process, calculate your DTI ratio. This will give you a good baseline for what you can afford and what you may need to do to get approved for a mortgage. Most people have debt — it’s far from a deal breaker — but it’s important to understand how your debt impacts your financial health every month. Once you have a grip on your DTI ratio, you’ll have a better chance of getting approved for a mortgage.