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.

Image: iStockphoto

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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!

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