If you’re preparing to buy a home in the future, you likely have a laundry list of things you need to do to get ready — and that includes getting your finances in tip-top shape.
Aside from double checking your credit score and credit report and making sure you have enough money saved up to purchase in your desired market, you should also consider the ways your current debt balance might affect your ability to buy a home.
1) It shows lenders you can handle paying back lenders
Having some debt on your credit report is still really important because lenders need “clues” about how good you are at managing different forms of debt. So having a student loan that you paid off on your credit report can be a green flag to lenders.
Or, maybe you’ve been managing two credit cards really well over the last five years; this is another positive trade line that will show up on your credit report and help you appear less risky as a borrower.
If you don’t have any history of managing debt — even one credit card — lenders may not feel comfortable giving you such a large loan because you lack those clues about your debt management habits.
Healthy debt management habits can set you up to have an easier time getting approved for your home loan. Not only do you have a history of managing debt, but you also have clues that point to positive management habits — and that can be reflected in your credit score.
Most mortgage lenders look for a credit score of at least 620. Some lenders, like Rocket Mortgage, may still consider applicants who have credit scores of at least 580 for some home loans. But the higher your credit score, the lower your mortgage interest rate will be. That’s why working to improve your credit score before you apply can work to your advantage.
Payment history makes up 35% of your credit score. So just by consistently making your credit card, auto loan and other payments every month, you’re contributing to improving your credit score. Likewise, if you were to miss a payment, this could have a big impact on your credit score.
The amount of money you owe is the second most important factor in determining your credit score (it makes up 30% of your score). This is usually a measure of your credit utilization, which is the amount of money you owe in relation to your total credit limit. Experts typically recommend keeping your credit utilization below 30%.
So if you have $5,000 as a total credit limit and owe $2,500, your credit utilization is 50% and it would be a good idea to continue making payments so you can lower your utilization.
Because of that credit utilization rate, carrying too much debt could drag down your credit score. Coming close to maxing out your available credit makes lenders think that you’re spending beyond your means and would therefore be a risky borrower.
One criteria mortgage lenders assess when reviewing your home loan application is known as the debt-to-income ratio. Your debt-to-income ratio is a comparison of how much you owe to how much money you earn. Your gross income (pre-tax income) is used to measure this number.
A lower debt-to-income ratio suggests that you have a healthy balance between debt and income. However, a higher debt-to-income ratio suggests that too much of your income is going toward paying down debt, and this will make a mortgage lender see you as a risky borrower.
According to a breakdown from The Mortgage Reports, a debt-to-income ratio of no more than 43% is considered good; a ratio closer to 45% might be acceptable depending on the loan you apply for, but a ratio that’s 50% or higher can raise some eyebrows.
A higher debt-to-income ratio could make you unable to be approved for some home loan programs with attractive features, like lower down payment minimums. For instance, the HomeReady loan program from Ally Bank requires applicants to have a debt-to-income ratio of no more than 50%, among other criteria.
If you want to calculate your debt-to-income ratio, here’s what you do: Add up all your monthly debt payments, which includes credit card payments, student loan payments and payments to any other lines of credit you may have. Then Divide this number by your gross income amount. The result is your debt-to-income ratio.
If you have an unhealthy amount of debt and are preparing to get a mortgage, consider these strategies to consolidate and pay down your debt.
The debt snowball method is one debt management method where you focus on eliminating the smallest debt balance first while paying just the minimum on all your other debts. On the other hand, the debt avalanche method, involves eliminating your highest-interest debt first. Both methods can be instrumental in helping you crush your debt balance in a more organized way.
Debt consolidation is another popular method for paying down debt if you carry balances on multiple credit cards or have multiple loans. Essentially, you’ll apply for a personal loan that’s enough to cover the total amount of debt on all your credit cards. Then, once you’re approved, the lender sends the funding amount to your creditors, which pays off your credit cards. From there, you’ll just have to pay back the personal loan you borrowed.
This method can potentially help you save on interest since personal loan lenders typically offer much lower interest rates compared to credit card issuers. The Marcus by Goldman Sachs Personal Loan is one of the best debt consolidation loans out there since this lender will send your funds directly to up to 10 creditors.