Your debt-to-income ratio is one way lenders measure your incoming cash flow and judge whether you have the ability to manage your monthly payments.
How Debt Impacts Homebuying Power
The importance of a credit score
The easiest way to gain perspective into how mortgage lenders will rate your readiness as a homebuyer is to look at your credit score — a three-digit mathematical analysis of your debt level, payment history and other financial data collected by the credit bureaus. That number, which ranges from 300 to 850, shows lenders how you handle your debts and liabilities — and how serious you are about being a homebuyer. The higher your credit score, the greater chance you have at being approved for a mortgage within your desired price range.
Types of debt
You should also know the two specific types of debt that make up your credit score: secured and unsecured. Secured debt is connected to an owned asset of value, such as a house or a car, that is considered to be collateral for the debt. If you fall behind on payments for a loan involving secured debt, lenders can assume ownership of those assets to cover your delinquent payments.
Unsecured debt, on the other hand, includes credit card balances, student loans, medical bills or court-ordered child support — generally, there is no collateral lenders can assume to cover a missed payment.
That doesn’t mean unsecured debt can be a detriment, or that having only secured debt will make you more favorable as a prospective loan recipient. Home lenders look at all aspects of your debt to understand what you’re using it for — for example, did you take out that loan to make an improvement, or did you use it for living expenses because you’re barely making ends meet? The context here is crucial.
Now, let’s evaluate the most widely-used types of secured and unsecured loans, and how the positives and negatives of each can affect your creditworthiness.
Student loans. For first-time homebuyers, student debt can actually be helpful. True, it’s a burdensome monthly payment that could affect your ability to save for a down payment. However, lenders can also view student loans as a sign that you take your liabilities seriously, and a perfect payment history is often viewed very favorably by lenders. Student loans can also help you establish a credit history at a young age.
Credit card debt. The most widely-used type of unsecured debt, credit card debt is often scrutinized by lenders. While credit cards can actually help you build a good credit history if you pay your debt in full each month or make payments that are substantially larger than the required monthly minimum, having multiple cards can be a red flag. Do you really need six cards? Are you running a high balance and only making minimum payments? If so, a mortgage lender may view you as cash-strapped, living card-to-card to maintain a lifestyle you can’t afford — and thus not a person who’s ready to trust with a six-figure home loan. Infrequent use of your credit card or having a minimal balance shouldn’t move the needle much.
- Auto loans. A car loan is a secured loan and, like the others, it helps to build your credit history. A $1,000 monthly payment on a car, on the other hand, may raise some questions.
- Other mortgages. If you already have a mortgage on another home and can demonstrate a positive pay history, lenders will feel more comfortable giving you another home mortgage because you’ve shown you know how to handle it responsibly. If that home is a cash-flow positive investment property, lenders may also give you higher marks because the rental income may help with mortgage payments. Conversely, if that second home is not rented, you must show lenders you have the income to carry loans on multiple properties. A general rule of thumb when multiple mortgages are involved is that the amount of the second loan shouldn’t be far higher than your first one — so don’t assume your perfect payment history on a $150,000 loan will mean you can easily get a new million-dollar loan.
Bankruptcy, liens and judgements all have significant negative impacts on your credit report, so it’s important to manage both secure and unsecure debt appropriately.
What’s your debt load?
After checking your credit score, check your debt-to-income ratio — which is one way lenders measure your incoming cash flow and judge whether you have the ability to manage your monthly payments, including those for the major home loan you’re seeking. The easiest way to calculate your debt-to-income ratio is to add up all your monthly debt payments and divide that amount by your gross monthly income.
The Consumer Financial Protection Bureau recommends that your debt-to-income ratio be no higher than 43 percent — meaning your monthly liabilities should be no higher than 43 percent of your monthly pre-tax gross income. For a home loan, factor everything involved in a home purchase into the debt amount — including taxes, insurance and other housing costs.
Lenders also look at the history and trajectory of your debt-to-income ratio. Say, for example, you increased your income from $100,000 to $250,000 in a year. A home lender may not automatically underwrite a much larger loan — they’ll want to understand the why behind the jump. Was it a big salary increase? A one-time sale of a house or stocks? Will that $250,000 income continue?
Prepare your debt for the homebuying process
Once you’ve made the mental decision that you want to buy a home, here’s your debt management to-do list:
- Make sure your credit is in order — check your free annual credit report.
- Figure out your debt-to-income ratio and determine how much more debt you can handle without drastically tipping the scales.
- Understand how much you can afford as a down payment — is it saved up, or will you get help from family?
- Have a cash cushion. Home lenders will look at how many months of cash reserves you have, so you should have enough saved to keep making mortgage payments for a few months if your income dips unexpectedly.
- Double-check your comfort level. Ask yourself again: Are you truly comfortable borrowing an amount into the six figures and making that monthly mortgage payment?
Read our Checklist for First-Time Homebuyers to understand all the appropriate paperwork you need to get the conversation started with a potential home lender about your homebuying desires and abilities. There’s no cost to get pre-approved or pre-qualified, and that process will give you a better understanding of what you can afford. That way, once you start looking at homes, you can better aim your sights on finding the house of your dreams — and you’ll know that you can afford it.
The strategies mentioned in this document may have tax and legal consequences; therefore, you should consult your own attorneys and/or tax advisors to understand the tax and legal consequences of any strategies mentioned in this document. First Republic Bank does not provide tax or legal advice.