How Debt Affects Homeownership

Blog posted On December 28, 2023

Homeownership is a classic part of the traditional American Dream. It represents not only financial stability but also a place to call your own. Getting approved for a home loan can feel daunting, especially if you're carrying a significant amount of debt. Debt affects your Debt-to-Income Ratio (DTI), which is a major part of the loan approval process.

Understanding debt-to-income ratio (DTI)

Your DTI is used to assess your ability to handle additional debt like a mortgage payment. It’s calculated by dividing your monthly debts by your monthly gross income. Once calculated, it’s written as a percentage. If your total monthly debt payments (including credit card bills, auto loans, student loans, and any other debts) amount to $2,000, and your gross monthly income is $6,000, your DTI would be 33.33% ($2,000 / $6,000 * 100). The lower the percentage, the better.

Types of debt

Debt comes in various forms. Lenders look at all forms of debt when calculating your DTI. Common forms of debt include:

  • Credit card: Balances on credit cards, especially high-interest ones, can significantly impact your DTI. Carrying large credit card balances can result in high minimum monthly payments
  • Auto loans
  • Student loans: Student loan payments, whether federal or private, count towards your DTI. These loans can be a significant burden for recent graduates
  • Personal loans
  • Other loans: This category includes payday loans, personal lines of credit, or any other forms of consumer debt

How debt affects loan approval

When applying for a home loan, lenders assess your creditworthiness and financial stability.

  • High DTI raises red flags: Lenders prefer borrowers with lower DTIs because it indicates that you have more disposable income to handle new debt obligations, such as a mortgage payment. A high DTI raises concerns about your ability to manage additional debt, making lenders hesitant to approve your application
  • Interest rates: Even if you are approved with a high DTI, there’s a chance of your interest rate being higher

How paying down debt can help with your mortgage

If you know that you’re going to be searching for a home, it’s important to put together a plan to pay down debt. A workable, realistic plan not only helps lenders see your worthiness as a borrower, it also gives you momentum to feel as if you’re making progress towards your goals.

  • Lower DTI: The most significant advantage of paying down debt is that it reduces your DTI. When you make consistent efforts to pay off your existing debts, your monthly obligations decrease, and your DTI falls
  • Increased loan amount: With a lower DTI, you may qualify for a higher loan amount, which can mean a bigger or newer home depending on the market you’re in
  • Potential for better interest rates: Lowering your DTI can also lead to more competitive interest rates. Favorable loans terms tend to be offered to borrowers with lower risk profiles
  • Improved credit score: Managing and paying off debt can positively impact your credit score. A higher credit score not only enhances your chances of loan approval but can also result in lower interest rates
  • Financial stability: Reducing debt demonstrates a commitment to financial stability. Lenders want to work with borrowers who are responsible and show a willingness to manage their finances effectively

Tips for tackling debt before applying for a home loan

If you're considering applying for a home loan, creating a plan that helps you pay down debt is a must.:

  • Create a budget: Create a budget that outlines your income and expenses. Tools like Every Dollar and YNAB are fantastic. Identify areas where you can cut spending to allocate more money toward debt repayment.
  • Prioritize high-interest debt: Focus on paying off high-interest debts first, as they cost you the most over time
  • Set up a debt repayment plan: Develop a strategy for paying off your debts systematically. Options include the snowball method (starting with the smallest debts) or the avalanche method (tackling high-interest debts first)
  • Avoid new debt: While working on paying off existing debt, avoid taking on new debt, such as credit card purchases or additional loans
  • Monitor your progress: Regularly review your debt reduction progress and adjust your strategy as needed. Celebrate small victories along the way to stay motivated

A lower DTI not only increases your likelihood of approval but also can lead to more favorable loan terms and lower overall borrowing costs. By managing and reducing your debt before applying for a mortgage, you demonstrate financial responsibility and enhance your prospects of achieving the dream of homeownership. If you’re a current homeowner, looking to pay down, I understand, ask us about our home equity options.