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 mortgage, but someone with a lower score still may be able to qualify. Or they might be eligible for an FHA- or VA-backed loan. The bottom line: The higher your score, the more options you can expect to have when applying for a loan.
A few factors go into determining a credit score, but payment history and credit usage are the categories that hold the most weight. Payment history takes into account your record of making on-time or late payments, or if you’ve filed for bankruptcy.
Credit usage looks at how much you owe in loans and on your credit cards. An important consideration in this category is your credit utilization rate, which is how much revolving credit you have available compared with how much you’re using. The lower your rate, the better. Most lenders prefer a utilization rate under 30%.
Does that mean you should pay off all credit card debt before buying a house?
Nope. Debt isn’t the devil when it comes to your credit score. Borrowers who show that they can responsibly manage some debt and make timely payments can expect to maintain a good score. Meanwhile, not having any credit history at all could be a problem when applying for a loan.
The key is consistency, so borrowers may want to avoid making big payments, big purchases or balance transfers as they go through the loan process. Mortgage underwriters may question any noticeable changes in your credit score during this time.
2. Don’t Forget, You May Need Ready Cash
Making big debt payments also could cause problems if it leaves you short of cash for other things you might need as you move through the home-buying process, including the following:
- Down Payment: Whether your goal is to put down 20% or a smaller amount (the median down payment for recent buyers was 12%, according to a 2021 National Association of Realtors report), you’ll want to have that money ready when you find the home you hope to buy.
- Closing Costs: The cost of home appraisals, inspections, title searches, etc., can add up quickly. Average closing costs are 2% to 5% of the full loan amount.
- Moving Expenses: Even a local move can cost hundreds or even thousands of dollars, so you’ll want to factor relocation expenses into your budget. If you’re moving for work, your employer could offer to cover some or all of those costs, but you may have to pay up front and wait to be reimbursed.
- Remodeling and Redecorating Costs: You may want to leave yourself a little cash to cover any new furniture, paint, renovation projects or other things you require to move into your home.
3. Be Aware of Housing Market Trends
Trends in the housing market may help you with prioritizing saving or paying down debt. So it’s a good idea to pay attention to what’s going on with the overall economy, your local real estate market and real estate trends in general.
Here are some things to watch for:
- Interest Rates: When interest rates are low, homeownership is more affordable. A lower interest rate keeps the monthly payment down and reduces the long-term cost of owning a home. Rising interest rates aren’t necessarily a bad thing, however, for buyers who’ve been struggling to find a home in a seller’s market. If higher rates thin the herd of potential buyers, a seller may be more open to negotiating and lowering a home’s listing price. Either way, it’s good to be aware of where rates are and where they might be going.
- Inventory: When you start your home search, you may want to check on the average amount of time homes in your desired location sit on the market. This can be a good indicator of how many houses are for sale in your area and how many buyers are out there looking. (A local real estate agent can help you get this information.) If inventory is low and buyers are snapping up houses, you may have trouble finding a house at the price you want to pay. If inventory is high, it’s considered a buyer’s market and you may be able to get a lower price on your dream home.
- Price: If you pay too much and then decide to sell, you could have a hard time recouping your money.
- The goal, of course, is to find the right home at the right price, with the right mortgage and interest rate, when you have your financial ducks in a row. If the trends are telling you to wait, you may decide to prioritize paying off your debts and working on your credit score.
4. Remember, You Can Modify Your Mortgage Terms
If you already have a mortgage, you can make some adjustments to the original loan by refinancing to different terms. Refinancing can help borrowers who are looking for a lower interest rate, a shorter loan term, or the opportunity to stop paying for private mortgage insurance or a mortgage insurance premium.
5. Consider a Debt Payoff Plan
If you decide to make paying down your debt your goal, it can be useful to come up with a plan that gets you where you want to be. Because here’s the thing: All debt is not created equal.
Credit card debt interest rates are typically higher than other types of borrowed money, so those balances are more expensive to carry over time. Also, lenders generally look at loans for education as “good debt” and credit card debt as “bad debt,” which means they might be more understanding about your student loan debt when you apply for a mortgage. (Car loans are usually categorized as somewhere in the middle of the two.)
As long as you’re making the required payments on all your obligations, it may make sense to focus on dumping some credit card debt. When you consolidate your credit card debt, you pay off each one of your credit cards with a single fixed-rate personal loan with a set term. The interest rate may be lower than the rates on your credit cards.
The Takeaway
Should you pay off debt before buying a house? Not necessarily, but you can expect lenders to take into consideration how much debt you have and what kind it is. Considering a solution that might reduce your payments or lower your interest rate could improve your chances of getting the home loan you want.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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What Credit Score is Needed to Buy a House?
What’s your number? That’s not a pickup line; it’s what a lender will want to know. The number will range from 300 to 850, and it will weigh heavily in whether you qualify for a conventional or government-backed loan and at what interest rate.
The national average credit score has inched up in the past few years, all within the range considered “good.” But applicants with “fair” and even “poor” credit scores can and do secure mortgages.
Below, we’ll cover the minimum credit score for a mortgage and how you can improve your credit score if needed.
Related: Understanding mortgage basics
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Lenders look at a credit score to help determine whether a potential borrower is trustworthy. Considering that the recent median home sale price was over $350,000 and that financial institutions hold about $10 trillion in mortgage debt, lenders want to know that a borrower is solid and that repayment will be made.
Credit scores were created by the Fair Isaac Corp. to put a simple numerical representation on a person’s history of obtaining and repaying debt.
There are now other institutions that also calculate credit scores, but FICO scores are the most commonly used. Experian, Transunion and Equifax are the three credit reporting agencies that collect information on your history of borrowing and then FICO or another company amalgamates the information into a score between 300 and 850.
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In general, those with a strong history of making on-time payments on their debts will have higher credit scores. Here’s what goes into calculating a credit score:
- Payment history (35%): Considers whether the applicant has made payments on time.
- Credit utilization (30%): The ratio of how much you could borrow from all accounts vs. how much you are borrowing. The lower your credit utilization, the better.
- Length of credit history (15%): Histories with accounts that have been open for longer are seen more favorably than those that have been open for less time.
- Types of credit (10%): Having multiple types of debt is preferable. Installment credit, such as an auto loan, personal loan, student loan or mortgage loan, and revolving credit, like a credit card, are both considered.
- New inquiries (10%): Each time a new inquiry on credit is made, there can be a negative effect on a credit score. Credit inquiries happen when opening credit cards and taking out loans, and even when a lender does a “hard pull” on your credit history.
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Here’s how credit scores are generally classified:
- Exceptional: 800-850
- Very good: 740-799
- Good: 670-739
- Fair: 580-669
- Very poor: 300-579
In general, lenders consider applicants with “bad” or “poor” credit score subprime borrowers. Depending on what type of mortgage loan an applicant is trying to acquire, it may be hard to obtain a loan with a credit score lower than around 600.
If you are trying to acquire a conventional loan, you’ll likely need a credit score of at least 620.
With an FHA loan, 580 is the minimum credit score to qualify for the 3.5% down payment advantage. Applicants with a score as low as 500 will have to put down 10%.
The FHA program was created to get applicants with lower credit scores into homes. The loans are insured by the Federal Housing Administration, so lenders are more lenient.
A VA loan usually requires a minimum score of 580 to 620; and a USDA loan, 640.
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Credit scores aren’t the only factor that lenders consider when reviewing a mortgage application. They will also require information on your employment, income, and bank accounts.
A lender facing someone with a low credit score may increase expectations in other areas like size of the down payment or income requirements.
The lowest credit scores that lenders are willing to accept change with the economic environment. During the housing crisis of 2008 and the years after, it was very difficult for borrowers with credit scores lower than 700 to obtain loans.
During better economic times, credit score requirements for borrowers may loosen. Therefore, it is a bit of a moving target to nail down the precise average or the lowest possible credit score one must have to receive a mortgage loan.
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Working to improve a credit score before applying for a home loan could save a borrower a lot of money in interest over time. Lower rates will keep monthly payments lower or even provide the ability to pay back the loan faster.
Let’s look at an example using a mortgage calculator: If you were take out a mortgage on a $400,000 home after putting 10% down with a 4.5% interest rate on a 30-year fixed rate mortgage, your monthly payment would be $1,824 and you would pay $296,663 total in interest over the life of the loan.
If you were to take out that same loan with a 5.5% rate of interest, your monthly payment would be $2,044 and you’d pay $375,854 total in interest. The difference of 1% in interest results in almost $80,000 paid over time.
Improving your credit score will take a bit of time, but it can be done. Here’s how.
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Reporting errors are quite common, so be certain that your credit history doesn’t mistake a missed payment or report a debt that’s not yours. You can get a free credit report
https://www.annualcreditreport.com/index.action
once a year from each of the three reporting agencies: Transunion, Experian and Equifax.
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If you haven’t been doing so, it could take up to six months of on-time payments to see a significant improvement.
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If you do not have credit established, an easy way to do so is by opening a credit card. But only do this if you are prepared to use the credit card responsibly. This means paying back the card, in full, each month. Do not simply pay the minimum payments.
If you are having trouble qualifying for a card, look into a secured credit card. With a secured card, you put a cash payment down that works as your line of credit, proving you can manage a credit card.
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This will increase your credit utilization ratio by showing that you have lots of available credit that you don’t use. It is best to keep the credit utilization ratio below 30%, meaning you’re only using 30% of your available credit at any time.
Understand that this number can be assessed at any time during the month, not just on the day that you pay your bills. Even if you pay your cards in full every month, if you’re consistently using more than 30% of your available limit, you could get dinged.
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If you are working to pay off credit cards, don’t close them once you’ve paid them off. Keep them open by charging a few items to the cards every month (and paying them back).
Remember, sources of debt that have been in use for longer are preferable to ones that are new. For example, if you have two credit cards, each has a credit limit of $5,000, and you have a $2,000 balance on each, you currently have a 40% credit utilization ratio. If you were to pay one of the two cards off and keep it open, your credit utilization would drop to 20%.
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If you have multiple credit cards and are struggling to manage them and pay them off, this might be a good solution. A personal loan may have a lower rate.
Another option for those with lower credit scores is to have a co-signer on a mortgage loan. If this person has a better credit score and financial situation than the main applicant, it could greatly improve the rate that a lender will offer. Only go down this route if this is a relationship that you can trust completely.
Once you feel that your credit score is ready, be sure to shop around for a home loan at several lenders. You want to be sure that you’re getting the best rate given your personal financial situation, and not every lender has the same criteria.
Know that even with credit scores that aren’t perfect, there are options for people who want to be homeowners; it’s just a matter of seeking out those options.
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What credit score is needed to buy a house? The numbers hinge on the economic climate, lender and type of loan, but those with imperfect credit often manage to secure home loans. First, know your credit score, take time to improve it if needed, and compare lender offers.
Learn More:
This article
originally appeared on SoFi.comand was
syndicated by MediaFeed.org.
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