Mortgages

The Right Way to Pay Off Debt to Get a Mortgage

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Trying to secure a mortgage right now? From higher mortgage rates, to rising home prices to the contraction in buying power — securing financing, for some, can be no easy endeavor. As prices, and rates rise simultaneously, lenders will still place the weighted emphasis on “real income,” or, the amount of monthly payment you can afford — as that’s what the loan is truly made against. Unfortunately, the amount of debt you have effectively chips away at your “real income.” So before you try to get a mortgage, you might want to pay down your debt. Just make sure you do it the right way.

Before I delve into the specifics, here are some quick terms you need to know:

  • Debt to income ratio (DTI): Represents the total amount of monthly debt payment (including the house payment) divided into monthly income. Whenever this number exceeds 45% of the gross monthly income, things get tricky.
  • Real Income: Also known as “qualifiable income,” the net income considered for the housing payment after present liabilities are factored in. If you have $5,000 in monthly income × .45, that gives you $2,250 as a total debt allowance. If your other debts total $250 per month, that means your real income is $2,000 per month. Real income is also equivalent to a proposed housing payment.
  • Debt: Refers specifically to the minimum payment obligations the consumer is responsible for. This has nothing to do with the total amount of debt, but what the monthly payments are. Lenders are looking for cash flow, how much or how little of it there is.

Tip: Debt erodes income (ability to borrow money) at a ratio of 2:1; it takes $2 of income to offset $1 of debt.

Now, the strategy for paying off debt to qualify differs when buying a house from refinancing. Let’s look at the differences:

Paying Off Debt When Buying a Home

When buying a home, and prior to attaining an accepted purchase offer, paying off debt to qualify is simply a function of learning how much more buying power is achievable by eliminating debt like credit cards, student loans or car loans.

A qualified mortgage lender can run “what if” possibilities, which could become crucial in your endeavor to purchase not only the right home, but ultimately the home you can afford. Let’s say there’s $5,000 left on your car loan, you have the cash in the bank and the car loan payment is $600 per month. $600 per month on a car loan reduces your ability to purchase to the tune of more than $100,000 in loan amount. Consider this: A $100,000 mortgage loan at 4.5% on a 30-year fixed rate mortgage translates to $506 per month, $94 per month less than if you didn’t have the debt. If you pay off the debt in full, your DTI is reduced, improving your ability to qualify and increasing your real income.

How to Pay Off the Debt and Still Meet the Lending Credit Standard

If you’re paying it off pre-contract, simply inform your mortgage company and they can do a third-party validation and the debt can be omitted. When paying off during the escrow process, monies will have to be sourced and paper trailed, which is a little more technical, but still achievable. The same goes for credit cards and other payment obligations.

Paying Off Debt When Refinancing

When you’re refinancing, the lender’s going to require that your credit obligations — such as a car loan or credit card — are paid off in full and closed to prevent the possibility of your accumulating further debt, thus potentially affecting your ability to repay in the future. Moreover, the lender would call for an escrow account to pay off the debt through the loan closing.

When it comes to paying off debt to qualify in refinancing, different lenders will vary on their specific approaches. Generally, though, the accounts will have to be closed as well. That won’t prevent you from reapplying for credit after the mortgage has closed, however.

How to Pay Off the Debt and Still Meet the Lending Credit Standard

The monies you use to pay off your debt, similar to a purchase transaction, will have to be sourced — and you’ll have to have proof that the obligation has been closed. If possible, pay the credit card in full, learn the date the creditor reports to the bureaus, then apply for the mortgage after the creditor has reported it to the bureaus. Doing this will show the updated balance on the credit report, which will improve real income (revealing less debt), making the process more streamlined.

If you have debt that otherwise could be eliminated and have the means to pay off the debt, strongly consider doing so, as higher credit risk mortgages tend to be more pricey overall — compared to those for borrowers with lower debt-to-income ratios and better credit scores.

As you get ready to buy a house or refinance your mortgage, it’s important to pull your credit reports and credit scores to see where you stand. You can get your credit reports for free once a year from each of the three credit reporting agencies, and you can monitor your credit score using a free tool like Credit.com’s Credit Report Card.

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  • Val Croft

    Scott,
    We have just closed on a home refi with a cash out option to pay off about $10,000 in credit card debt. FYI our debt to income ratio is approx 22%. Four days after we closed our credit union is asking that I sign forms to close my credit cards. This was never disclosed as a condition to the loan, my documentation with the credit union shows payoff only. I am not comfortable with closing my 2 credit cards. What are my options? Thanks so much.

    • http://www.credit.com/ Credit.com Credit Experts

      From Scott Sheldon:

      First off congratulations being able to keep your debt loads low, a 22% debt
      to income ratio is fantastic! Cash out refi usually does not have an
      option to pay off credit cards but rather happens in one of two ways.
      The first way is that you did receive a $10,000 cash after-the-fact and
      then in it becomes your choice to pay off the credit cards or, it was a
      requirement of the loan to pay off debt to qualify which is what it
      sounds like wherein these credit cards would’ve been paid off through
      the close of escrow. It sounds as if that’s what transpired based on
      your description. If the loan was set up with you paying off the credit
      cards and a credit union was notified, you might want to ask your credit
      union since the refi has already happened if you can keep the cards
      open. Otherwise, you may have to close the cards and then reopen them
      after-the-fact. Hope this helps!

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  • ScottSheldonLoans

    Hi Dave,

    Because you are a sole proprietor is little bit different.
    You need to show the business debts are paid for by the business, identified on
    your schedule C. If they are not paid by the business then they become a
    personal liability and they will affect your debt to income ratio in that
    particular instance. Your personal debts for $500 per month, would need to be
    paid off prior to closing escrow and would have to be subsequently closed in
    order for the lender to not account for the $500 per month liability against
    your income. The key here is that it has to be paid off and closed in can’t
    just simply be paid off because the credit line would remain open which would
    further mean you could accumulate debt again. After-the-fact, you could always
    open up a credit card again anyway. Hope this helps with your situation.

  • ScottSheldonLoans

    Yes, you would need to provide a lien release from the lender because it’s not been report to the credit bureaus that quickly.

  • JJ

    Hi Scott, How long do I have to wait in order to apply credit after the escrow is closed??? I’m trying to buy some new furniture for my new home

    • ScottSheldonLoans

      JJ,

      Good question, as soon as escrow/transaction “records” , you’re good.

  • Amy

    Hi Scott, great info! Quick question- We are pre-ratified contract and completed pre-qualification and approval for mortgage. Loan officer today said our DTI is great until they run the “worst case scenario” of Max 2% increase in 5 years after 5yr fixed rate. We discussed several options and I was told lowering our monthly car payment would improve our ratio. I was concerned about having credit pulled to refi car loan or purchase car with lower payment & was told that would not be an issue since credit was already pulled its valid for 4 months. Does this seem accurate? I’ll gladly get a lower car payment.

    • ScottSheldonLoans

      Amy,

      Thanks for the question sounds like you are taking an arm loan, am I right? If yes, and the DTI has a chance of being too high sounds like maybe you are qualifying on the teaser rate to squeeze in? If yes, I would really invest the time to make sure you all all the faucets your lender is working with. A credit report for mortgage purposes is good for 60 days after which if the loan hasn’t closed they’d need to repull credit. A new car loan cause a debt to income issue if its a new car loan or the payment is higher. Generally, a credit pull for a car loan won’t adversely affect your score and could improve your debt to income ratio especially ( lowering dti) if the car payment is lower. My advice? Ask your loan professional what the car payment would need to be to keep your debt to income ratio in safe range and consider a 30 year fixed. I tell home buyer’s if you cannot afford a 30 year fixed rate payment with taxes and insurance, then don’t buy the house or reduce your price range to a payment more in line with your income and liabilities. Good luck out there!

  • ScottSheldonLoans

    Hi there,

    I would pay off the car, as the car probably has the largest
    minimum monthly payment due.I could be wrong, but in my experience car
    payments are substantially more than a credit card payment or even a student
    loan payment. Since the reality of it is that you’re going to be purchasing a
    home with some form of consumer debt the key here is to do it with as
    lowest possible minimum monthly payments on consumer liabilities as possible
    which means getting rid of the car- translates to the biggest bang for your buck in terms
    of borrowing ability. I wouldn’t worry too much about your credit score
    dropping by paying off the car either. Once the car payment is gone, that
    payment can go towards saving up for the monies to buy a home or for doing
    exactly what you mentioned, paying off consumer liabilities.

  • http://www.Credit.com/ Gerri Detweiler

    The problem with rolling those loans into a mortgage is that a. you’ll take much longer to pay them off and b. you are putting your home at risk for consumer debt. If you can’t pay your credit card or auto loan, they can’t take your home. But if you can’t pay your mortgage, you could lose the roof over your head.

  • http://www.Credit.com/ Gerri Detweiler

    A personal loan could be a good idea. If you can get a loan at a decent fixed rate and then pay the $500 a month you were paying on your car toward this debt it sounds like you could pay it off in about 48 months. If you decide to buy a home during that time, the payment on that loan will figure into your debt ratio, but so would your credit card payments if you left the debt on your cards. If you can add the amount that you are currently pain in your credit card to the loan payment you may be able to pay it off even faster. You can search personal loans here.

  • http://www.Credit.com/ Gerri Detweiler

    Ashleigh,

    Are you taking out federal student loans or private student loans? Federal student loans are much safer generally than private loans.

    The other question is whether you are building any kind of savings. Are you able to set any money aside or using it off pay off the car loan?

  • http://www.Credit.com/ Gerri Detweiler

    Megan,

    Your best bet is to talk with a mortgage professional who can look at all of your information to see if you’re ready to qualify. However, I would caution you about trying to take on new debt when you aren’t currently paying your student loan debt. To have a plan for tackling this debt when it is out of deferment?

    I’d also suggest you read this article: How Student Loans Can Hurt Your Mortgage Application

  • ScottSheldonLoans

    Sean yes you will. Once the UW see its, they cannot just ignore it.

  • http://www.credit.com/ Credit.com Credit Experts

    We wish there were an easy answer to your question. Delinquent accounts stay on your credit report for 7.5 years after the original account was reported late. Repaying the debt doesn’t make it disappear from your credit report, unfortunately. You can and should keep an eye on your scores to make sure you are on track. Here’s how to monitor your credit score for free.

    You’ll find more information here:
    How to Fix Your Credit Score When Buying a Home

    The First Thing to Do Before Buying a Home

  • http://www.Credit.com/ Gerri Detweiler

    Nancy – Did you talk with your loan officer about this strategy? If you have an experienced loan officer they should be able to provide some direction. After all, that’s how they get paid is by making loans!

  • ScottSheldonLoans

    Nancy,
    Yes,you should be able to take the monies in your bank account and use those to pay off debt to qualify. However before you do that, if your debt ratio is literally only 45.1, try to get the interest rate lower with the lender .125% or get the hazard insurance reduced. One of those directions might be faster, and easier and you don’t need any of your own cash typically to do that unless your pain discount points to purchase the interest rate down .125%. That’s probably a better direction to take because lenders still allow loans up to 45% debt to income/payment income ratio.

  • ScottSheldonLoans

    You guys can pay off those liabilities and apply for a mortgage within just a few short weeks of doing so just make sure to tell the lender that you just did this action that they might have to do with color rapid rescore where they get your credit score changed by virtue of paying off previous liabilities.

  • ScottSheldonLoans

    Hi there no the plan won’t be considered, the debt would need to be paid off if that’s a hold back from loan approval.Can’t count his income for qualifying unless he is on the loan.

  • ScottSheldonLoans

    All the lender can do is give you suggestions to reduce the debt to income ratio. If they’re trying to reduce the debt to income ratio and the lease payment will fix that, then all they need is documentation to show the lease is no longer in effect and that you guys own title to the car without the obligation to make payments on it to the creditor.

  • http://www.Credit.com/ Gerri Detweiler

    It is perfectly fine to pay off your student loans. They won’t disappear from your credit reports when they are paid off, and if they had on-time payments those will still help the overall credit score.

  • http://www.credit.com/ Credit.com Credit Experts

    Possibly. Prices vary widely, and it would also depend on your credit. You’ll want to check your credit reports for accuracy. Here’s how to get your free annual credit reports. And you can also get free credit scores from Credit.com. That way, you’ll have an idea of where you stand credit wise.

  • LittleBritches

    I want to buy a home, I tried to pre-qualified but the lender said I had some old debt/collections agencies on my report. That I would have to pay them off before they would make any loans. I checked my report and most of them are zombie debt agencies collecting on debt that is over 6-10 yrs old. Some are schedule to “fall off” my credit report in 3 months to a 1 yr. One one account it has been sold 4 times!! What do I do?

  • http://www.Credit.com/ Gerri Detweiler

    It’s great that your fiance is making progress paying off debt. And I hate to be the bearer of bad news, but it sounds like you may have to put your homebuying plans on hold while your fiance works on his credit scores. Raising a score that much in a short period of time is difficult. For one thing, paying off collection accounts typically does little to boost your credit scores (and that’s certainly true under the scoring models most mortgage lenders use).

    It sounds like he has multiple negative accounts on his credit and not much in the way of recent positive information. The secured card can help (if he keeps the balances super low) but it’s not an overnight thing. It will take time to build up positive payment history and for the negative history to “age” or become older. He certainly should monitor his credit scores and once he gets into the low 600s (using the same FICO models mortgage lenders use) you can talk with a mortgage lender to see what else you need to do to qualify. I hope that helps!

    • http://www.Credit.com/ Gerri Detweiler

      Ricky – Mind sharing your phone number so I can reach out to you that way? Comments are moderated so we won’t publish it.

  • http://www.Credit.com/ Gerri Detweiler

    We published an article on this topic recently: I Have Unpaid Debt on My Credit Report. Can I Still Get a Mortgage?

  • Jay

    Scott/Gerri,

    I’d appreciate a little guidance from you guys, my current situation is as follows. I am looking into buying a home a next year between the price ranges of 350k to 500k. I apllied for a pre approval letter last year and was offered 300k. I have car loan which I owe about 11k (its the highest monthly by over $300.00) and 2 school loans at 3.5k and 15k. I just purchased some furniture with a loan from a bank because it was no interest for 4 years, and that is about 4.5k. I got a credit card last year because I didn’t have any revolving credit and now my score has come from 650 to 715, and I pay the card off monthly. I’d like to see if paying off my loans in full will help me increase this amount. I wasn’t going to pay the furniture off because I was told lenders typically like to see a couple of years of payments prior to paying things off? I make about 14k/mo., but that includes about 8k considered as bonus not salary (not sure if lenders consider the bonus as part of the income), and I would be able to pay these right now and still have funds in the bank. In essence I would be debt free, minus the credit card which I use to pay bills with and pay off every month. Your advice is much appreciated. Thanks.

    • http://www.Credit.com/ Gerri Detweiler

      How is the furniture loan reported on your credit reports? As as revolving account or installment account? If it’s a revolving account then the important factor there is utilization. If the reported balance is high in comparison to the credit limit then paying it down could boost your credit scores. You might try paying it down to 10% of the available credit to see what that does to your scores.

      Paying down installment accounts can help though typically not as much. Again you could pay it down to that level, keep a small balance and see what that does to your scores. Paying it down to 10% of the credit limit/high balance shouldn’t hurt and may help, but I never like to guarantee what will happen with one particular action – there are too many moving parts in credit scores to say for certain!

  • Ashleylou08

    I have a question. So I have been blessed with outside resources to pay for my car and a previous home in full. I have no debt. But I also have no credit. I’ve heard the phrase “no credit can be as bad as bad credit”. So my question is this. I will be purchasing a new home again soon but will be needing a mortgage. Is it better for me to open a credit card at say Best Buy and finance something and pay it off within the first few payments to have some form if credit before meeting with the lender? Or an I better of not opening any credit cards at all and having to out down a larger down payment? My fiancé is the breadwinner at the moment and has decent credit but also has a car payment. But While I don’t have credit I do have a nice chunk if money in my savings. What do you think out best option is?

    • http://www.credit.com/ Credit.com Credit Experts

      You may want to start with a secured card or what a credit union calls a “credit builder” loan. Here’s how a secured card could help: How Secured Cards Help Build Credit. A credit builder loan is one in which you essentially borrow from yourself (you put the amount “borrowed” in savings at a credit union and borrow that amount (at a relatively low interest rate). In both cases, pay on time. And check your credit reports. Here’s how to get your free annual credit reports. Also, monitor your credit scores. If you are a credit “ghost” now, you can find that out, and you should relatively quickly see that you begin to have a score. Here’s how to monitor your credit score for free. One more strategy might be having your fiancé add you as an authorized user on his credit cards. Good luck on your new home.

  • http://www.Credit.com/ Gerri Detweiler

    There are so many moving parts to a credit score – and so many different models – that it’s impossible to say that you should do exactly this or that. Paying off debt is also tricky. The mortgage company won’t look at you negatively because you’ve paid off debt. They just want the score. And in the case of the installment loan, paying it off completely could mean you have fewer open installment accounts which could potentially impact your score, but it depends on everything else in your report.

    I suggest you ask the lender who gave you the preapproval lender what you need to do to get preapproved for a larger amount. They have the full picture – income, assets, credit scores etc and are in the best position to advise you on next steps.

    • ScottSheldonLoans

      This would help your score with the debt pay downs and opening the amount of free credit available. Also paying off the debt would help mean you could take on more mortgage payment and potentially not have any disturbance to your cash flow as you would be replacing bad debt with good debt.

  • CJR

    I would love some advice before I start the home buying process. My fiance and I have about $10k combined credit card debt and 2 car loans at about $20k each. We have credit scores in the 700s but don’t have much money to put towards a down payment. Would you suggest trying to pay off credit first, or start saving more for a down payment? Thank you!

  • Josh F

    Hello,
    I have a question regarding what to do with the money from the sale of my current home. We are building a new home for around 425K, we have car loans and student loan debt that totals approximately 55k. Would it be better to pay off all of our non mortgage debt with the proceeds from the sale of our current home or put all of the money towards the new home? If we put all of the money from the sale of our current home towards the new home, it will equal to roughly 20% of the sales price.
    Thank you,
    Josh

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