Contributing Writer at Tally
October 24, 2019
One major obstacle preventing Millennials from buying a house is not fully understanding the income and credit requirements that come with mortgages. Luckily, it’s not too difficult once you grasp a few key concepts.
When it comes down to it, lenders want to make sure you’re both willing and able to buy a house that you can reasonably afford. And because credit card debt is so prevalent among Americans, it can be a major contributing factor in how much you can spend on a home and how much you pay in interest.
Here’s what you should know about how your mortgage application is evaluated and what you can do to make it as strong as possible, even with credit card debt.
Your credit score is one of the biggest factors affecting the interest rate on your mortgage. Because mortgages last so long (most commonly 30 years), securing the lowest interest rate possible can save you thousands of dollars or more in the long run. The best way to do this is to know what can hurt your credit score and then to maximize the highest-impact areas.
Your credit score suffers when you have a lot of credit card debt. The general rule is to keep your credit utilization under 30%, meaning your outstanding balances should be no more than 30% of your total credit limit. This applies to each specific card, as well as your overall credit limit. Avoid maxing out your credit cards to optimize this component of your score.
Late credit card payments can also lower your credit score. It’s still possible to get a mortgage with credit card late payments, but you may have to write a letter of explanation and give a reason for each late payment. If you have time before starting the process to buy a house, make it a priority to pay your bills on time to build a solid credit history.
All of your collective debt, including credit card balances, impacts another important number in your mortgage application: your debt-to-income ratio. Also called your DTI, this is an important concept to understand because it directly affects your purchasing power if you want to buy a house.
How do you determine your DTI?
First, add up all your monthly debt payments, including student loans, car payments and minimum payments toward your credit cards. Then, divide that number by your monthly gross income, which includes the total amount before taxes, health care and any other deductions.
When applying for a mortgage, your lender also includes your future house payment as part of your total monthly debt — and not just your principal and interest. It also includes your estimated taxes and homeowners insurance, divided for each month of the year.
Each lender has its own DTI limit, but most allow no more than 43%. Your monthly mortgage payment is required to fit within that ratio. If you have excessive credit card debt, you’ll limit how much you can spend on a house, no matter how much you make.
Lenders look at a few other things, in addition to reviewing your credit report, credit score and DTI. Much of the approval process depends on the type of home loan you choose.
Each mortgage requires a minimum down payment, which is determined as a percentage of the home’s purchase price. Here’s an example:
An FHA loan requires a 3.5% down payment if your credit score is at least 580. That means a $200,000 home requires a $7,000 down payment.
With a lower credit score, you’d need to make a 10% down payment. And for that same $10,000 house, you’d need to make a $20,000 down payment.
The upside is that paying more money upfront means you end up borrowing less. That can save you money on your monthly mortgage payments, as well as the amount you spend on interest over time. Even if a loan type has a minimum down payment, you can always pay more upfront.
Before you start your home search, try to get your credit card debt under control as much as possible. It’s entirely possible to buy a home if you have credit card debt, but lowering your amount of debt can help you qualify for better interest rates and can give you more options when it comes to purchase price.
Start by determining how much money you can reasonably put toward paying off your credit cards each month. If possible, go above and beyond the minimum payment so you can expedite the process.
Then, get strategic and determine the best order to focus your extra payments. Once all of your minimums are met, put any money left over toward the credit card balance with the highest interest rate — this is known as the debt avalanche method.
Put simply, anything you can do to decrease your amount of credit card debt, while also boosting your credit score, will work in your favor. It not only helps you qualify for a home loan, but can also help you qualify for a better loan. A mortgage is a long-term commitment, so it’s best not to rush.