There are very few things that can put your financial past and present under a high-intensity microscope quite like the mortgage approval process. After all, for many this is the largest loan with the longest repayment period they will ever commit to.
If this seems like a huge amount of pressure and a high financial bar to reach, it can be. But that doesn’t mean a less than stellar financial past or a current debt burden will put you out of the running altogether. It’s simply a matter of knowing how these things factor into the overall loan approval process and getting your financial ducks in a row beforehand.
Here are a few questions to ask yourself about your debt before applying for a mortgage.
What kind of debt do you have?
Debt might all seem equal, but the types of debt you carry can certainly play a part in your overall loan worthiness.
Your credit mix, for instance, impacts 10% of your credit score. Lenders want to see a mix of unsecured or revolving debt (like credit cards), secured debt (like auto loans), and installment debt (like student loans). If, instead, you just carry a large amount of credit card debt, this could lower your score and raise a red flag to lenders.
What is your debt-to-income ratio and housing ratio?
In order to determine your ability to take on a mortgage while still staying solvent with the rest of your debt payments, lenders will look at two different numbers: your front-end ratio (housing ratio) and your back-end ratio (debt-to-income ratio).
Your front-end ratio is your total monthly housing payment (including PMI, taxes, insurance, etc.), divided by your monthly income. Your back-end ratio is all of your current debt payments (student loans, child support, credit cards, etc.), divided by your monthly household income. The former should be at or below 28% and the latter should be at or below 36%.
If you have high debt payments, you could fall outside of these parameters and be denied for a mortgage altogether.
Are your debt payments current?
Simply carrying debt won’t disqualify you from getting approved for a loan, but not staying current on that debt certainly could.
According to Credit.com, lenders will weigh late payments and delinquencies a little differently. Late payments on credit cards could require a larger down payment and more scrutiny on your debt-to-income ratio. Late student loan payments on federal student loans could take you out of the running for a FHA loan. Late mortgage payments will need to be fully explained and documented.
In addition, your credit score could be significantly lower if you’ve defaulted on debt in the past, because payment history comprises a whopping 35% of your overall score.
Regardless of the type of debt you are behind on, or have been behind on in the past, your loan terms could be less favorable than they might have been otherwise.
What is your credit utilization ratio?
Another component of your credit score and an important number to lenders is your credit utilization ratio. This is a calculation of how much credit you are currently using vs. how much you have available to you.
If, for instance, you have a credit card with a limit of $1,000 and you have $900 charged to it, your credit utilization ratio on this particular card is a high 90%. According to experts, the target should be 30% or below.
This makes up another 30% of your credit score calculation and can show lenders you either have room to breathe or you are maxed out with your debt obligations.
The bottom line: Know your debt story before applying for a mortgage
While debt won’t necessarily hinder your ability to get approved for a mortgage, there are many things lenders will look at in order to determine how risky of a borrower you actually are.
By understanding what lenders are looking at beforehand, you can work to improve your payment history, raise your credit score, create a plan to pay off your debt faster, or fix anything else to help you to look like a top-notch candidate for a mortgage. Better yet, it will stabilize your financial footing and ensure you can handle the mortgage you hope to take on.