Are you considering buying a house? If yes, your monthly debt obligations play a significant role in your ability to qualify for a mortgage loan. So next time you are contemplating purchasing a great new car or truck, be aware of the fact a new auto loan payment will reduce your ability to get a mortgage.
Every debt showing on your personal credit report with a monthly revolving payment will be factored into your debt-to-income ratio. Meaning, if you have credit cards you use on a monthly basis and pay off in full each month, those minimum monthly payments will be used and your qualifying ability will be reduced. If the debt is not on a credit report - like child support or alimony - those items will also be factored into your purchasing power because they’re on your tax returns or bank statements. These items are always located on separation agreements or divorce decrees.
How debt affects purchasing power when buying a house
Debt affecting purchasing power works like this: gross monthly income-less any monthly debt obligations like credit cards or other loans etc. - multiplied by the maximum debt-to-income ratio the lender uses. (This varies from loan program to loan program.)
Let’s say our fictitious borrower, "John," has a gross monthly income of $7,500 per month and child support payments of $300 per month. He also has a student loan for $80 per month, as well as an auto loan, which is another $250 per month. All in all, John’s monthly debt before a house payment is $630 per month.
How much is John’s purchasing power affected by the $630 per month? Well let’s assume he’s going for an FHA loan. FHA loans typically don’t allow debt-to-income ratios greater than 45 percent, although in some cases that number could be exceeded. This means in John’s scenario, the maximum total monthly house payment he can qualify for is $3091.50 per month.
Know which loan program will affect your purchasing power the most
Here are some things to consider when looking at loan programs:
FHA loans typically have debt-to-income ratio requirements of no more than 45 percent of the gross monthly income, including all other monthly debts.
USDA mortgage loans require the debt-to-income ratio not exceed 43 percent of the gross monthly income considering other debt obligations.
Conventional home mortgages usually require the debt-to-income ratio to be no more than 45 percent of the gross monthly income.
Sometimes these numbers can deviate based upon compensating factors. Compensating factors are little "plus-signs" lenders give to offset standard underwriting. When qualifying for a house, lenders are looking for a full credit package, which includes proof of income, proof of assets and a healthy credit score.
If the credit score is higher, say 740 or better, sometimes the lender will allow a higher debt-to-income ratio. If there is a bigger down payment, that is another sign of a good compensating factor to provide loan qualifying flexibility.
When buying a house, it’s all about housing/debt ratios
In order of priority, here is the way mortgage lenders look at a file:
Housing/debt ratios
Credit score
Assets (if needed for down payment)
While the debt-to-income ratio is important, lenders also look at the housing ratio, sometimes called "the front end ratio." This is the total house payment divided by the borrower’s gross monthly income. If we go back to John’s scenario, his housing ratio is 41 percent, which is a little high, but if John has an 800 credit score, the file will be approved for financing.
Let’s take a look at what unsecured debt does to a home purchase price:
$250 per month reduces the purchase price by $50,000
$500 per month reduces the purchase price by $100,000
$1000 per month reduces the purchase price by $150,000, sometimes more.
Here are three different solutions plus a bonus tip to solve the negative affect monthly debts have on purchasing power:
Get more income
Reduce your purchase price
Eliminate monthly debts
Bonus Tip: Refinance monthly debts
Getting more income might be kind of difficult, unless you get a raise or there is a co-borrower possibility. Reducing the purchase price is always an option and eliminating monthly debts could also work.
Wait a second - I can refinance monthly debts to qualify for more house? Bingo! Yes, you can.
You can refinance that auto loan for a lower monthly payment to help you qualify for buying a house. If you have a mortgage already on another property, same thing; you can refinance the mortgage for a lower monthly payment to help you qualify.
Note: if you presently have an adjustable rate mortgage as your first or second mortgage on another property, the lender is going to have to "gross up" that mortgage to the maximum rate allowed under its note because it’s an adjustable.
Take heed: if your current first mortgage is an adjustable-rate mortgage, even if the rate is super low, the lender may have to tack on at least another 3 percent on top of it for qualifying purposes and qualify you with a higher payment because the mortgage is not fixed.
It’s simply a factor of risk-based underwriting. If you have a home-equity line of credit in the form of a second mortgage, that payment for underwriting purposes will be calculated at 1 percent of the total line amount divided by 12, which is almost always higher than what the actual payment is.
OK, so far so good, but what if you are buying a house and there are monthly debts on your credit report that are not yours? This can be a double-edged sword. If there are business loans on your personal credit report paid for by the business, in the eyes of the credit bureaus you are responsible for those monthly debts because they’re showing up on your personal credit report.
Co-signing an auto loan for a friend
Even though their vehicle loan is not yours, it will show up on your credit report. And since it’s showing up on your credit report, you have a personal obligation to repay that debt and that will be factored into your debt-to-income ratios, in turn affecting your purchasing power.
Deferred student loans
What if your student loans are deferred and you’re not responsible for paying on them for another four years? This depends on the loan program you’re going with. On an FHA loan, this is correct, on other types of loans such as USDA mortgages, that monthly payment has to be factored in now.
Buy a house and maximize purchasing power
What’s a better type of debt to have? A monthly credit card bill or mortgage loan? A home mortgage loan can radically increase your credit score and it’s tax-deductible, a credit card doesn’t keep a roof over your head. Want to find out how your own monthly debts will affect your purchasing power? Start by getting a free mortgage rate quote today.
Scott Sheldon is an FHA specialist, a local lender who helps with refinancing and purchasing, and a Senior Mortgage Loan Originator with over six years of mortgage experience. He can be reached at (707) 217-4000. at www.sonomacountymortgages.com/2011/06/02/stillrefinance/#ixzz1SbFRSopJ
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