When I was about to graduate college, one of my dad’s friends put his arm around my shoulder to pass along a few words of wisdom: “Never spend as much as you make, kid.”
We get lots of advice when we’re first starting out, most of it unsolicited and much of it forgettable. And yet we always know when we missed out on the good stuff—the advice we wished we’d had when it could have made a difference. Specifically, I’m talking about college graduates today who are having difficulties getting a mortgage because of the outsize debt loads they’ve taken on. A recent study by Young Invincibles underscores this problem
So how do you know if your debt is hurting your chances of getting a mortgage? There are guidelines. The YI report focuses on two types of debt-to-income ratios that are taken into account when mortgage applications are evaluated:
- The “front-end” ratio divides all of your monthly housing costs (mortgage, homeowner’s insurance and real estate taxes) by the amount of money you earn before taxes.
- The “back-end type” is more comprehensive. It divides all of the aforementioned housing costs PLUS all of your other debt obligations (student loans, credit cards, auto loans, and so forth) by pretax income.
The Federal Housing Authority (FHA), which makes low-down payment mortgage loans, limits total housing costs to no more than 31% of your pretax income; 43% for the all-encompassing back-end ratio. Other lenders set their own parameters, and in all cases, credit scores and credit bureau reports are also taken into effect. Obviously this would have been good for students to know way back when — before they got so deep in debt– but we are where we are, so let’s talk about dealing with the ratio problems that exist today.
If purchasing a house is important to you, and if you’re one of the many who are unable to pass the aforementioned debt-to-income tests, you have a couple of choices — either put up more money for the down payment or take the time to improve your standing. Here’s how you can do that.
Start with your budget. Your goals should be to maximize income and minimize expenses. Taking income first, and whether a higher paying job or after-hours work is an option, know that lenders often take a pretty broad view of what constitutes “gross income.” For example, the FHA (and others) may choose to define it to incorporate wages, salaries and tips—for your full and part-time jobs—as well as taxable interest, dividends, refunds (such as from your state income tax), capital gains and other taxable income.
As for your expenses, eliminate the excesses—especially those that can get you deeper in debt such as for credit card charges that morph into carried balances).
Next, refinance whatever debt warrants it. Start by attacking all your higher-interest loans, such as for credit cards and personal lines of credit. Just be sure to factor the annual percentage rate (APR) into your decision making process.
For example, suppose you’re carrying a balance on a credit card that charges 24% interest and you have an opportunity to transfer it to one that charges 16.4%. Sounds good, but what about the balance transfer fee? Suppose the new card charges 4% for that? Well, by using an APR calculator you realize you have nothing to gain. That’s because after taking the 4% fee into effect, the 16.4% card will end up costing 23.99%.
Your next step should be to apply for relief. To the extent that you have education loans that total more than 10% of your pretax salary, check out the government’s Income-Based Repayment Plan (IBR), which pegs household income to loan payment affordability, as well as its Loan Consolidation and Public Service Loan Forgiveness programs. And if you borrowed from private lenders, press them to extend the durations of your loans, which is about as much as you can hope for from the financial services industry until a more comprehensive solution to this crisis is enacted, once and for all.
Keep in mind, though, extending loan durations isn’t the same as lowering an interest rate or forgiving a portion of an outstanding balance. Yes, your monthly payment will go down and your debt-to-income ratios will improve, but the total amount of interest you’ll end up paying will go up because the loan will take longer to pay off.
Last, take a look at the things you own and consider selling what you don’t need. Whether via Craigslist or eBay, or by any other means, just be sure to use the proceeds to pay down principal as opposed to making a few extra payments ahead of time. That’s because loan payments are comprised of principal and interest. Therefore, paying ahead will reward your lender at your expense. Afterward, consider refinancing or recasting your newly diminished balance to reduce the payments going forward.
The net result of all this will be an improved debt-to-income position and a stronger credit bureau report. Your FICO score will probably take a little longer to catch up but don’t let that concern you in the short run. When all is said and done, credit scores are nothing more than a naturally occurring byproduct of the financial life you live—attend to the fundamentals and your score will ultimately reflect the work you’ve done and lead to the lower rates and better terms you deserve.
As for the advice we wish we’d had when it could have made a difference, how about “Manage your dollars a quarter at a time”? Think of your salary as the sum of four equal parts—assume 25% for taxes, limit housing and debt payment costs to no more than 25% each and you’ll end up with 25% or more for everything else, including savings.
Image: Dan Previte, via Flickr