How to Manage Your Debt Before Buying a House

Buying a house and getting a mortgage is a big investment– and not only for you.

When you choose a mortgage lender and are approved for your home loan, your lender is agreeing to lend you all funds necessary to cover your home purchase. Because a house is a high-cost purchase, lenders want to guarantee that you’re not a “risky borrower.” Lenders want to know that you’ll be able to make your monthly payments on time and in full.

How do lenders decide whether you’re a risk?

In most cases, mortgage lenders, or their underwriters, to be exact, will take a look at how well you’ve managed debt in the past, and how well you’re managing debt currently.

So, having debt can be a good thing. 

This may seem counterintuitive because if you’re buying a house, you’d want to save as much money as you can. And you probably wouldn’t want your money tied up in other debts, right?

Yes, saving money is always a good idea. But having some debt before buying your house can actually be an important factor in getting approved for a mortgage.

Why Debt Matters

To see how well you manage your debts, mortgage underwriters will take a detailed look at your credit score/credit history and your debt-to-income ratio (DTI).

Generally, you’ll want to have a high credit score and a low DTI. A high credit score indicates that you manage your debts responsibly. A low DTI indicates that you don’t have too much of your income tied up in paying off those debts.

Let’s take a closer look at both factors:

Your Credit Score

Each factor in your credit score is defined by debt. And to create and increase your credit score, you need to take on debt and manage it responsibly.

Your credit score is usually impacted by the following five factors:

• Payment history — Your payment track record is the most important factor considered in your credit score. Lenders want to know if you’re a trustworthy borrower. And so, they want to see if you make on-time payments on other debts.
• Credit utilization (or amounts owed) — Owing money on your credit cards, in particular, is not a bad thing. But, if you’re using too much at one time, underwriters might take that to mean that you’re overextending yourself financially.
• Length of credit history — A longer credit history is favorable. But if your credit history is limited, you won’t necessarily be disqualified from borrowing money.
• Credit mix — Underwriters want to see how you manage different types of debt.
• New credit — If you’ve opened multiple credit accounts at one time, this is a red flag for underwriters because it can suggest that you’re in financial distress.

For a mortgage, you’ll typically need a credit score of at least 620 for a conventional loan. But, it could be best to shoot for a credit score of 700 or above. A higher credit score increases your chances of approval, and also increases the loan amount that you’ll be approved for. But a high credit score could also help you secure a lower mortgage rate, which could save you a significant amount of money over the life of your home loan.

Your Debt-to-Income Ratio (DTI)

Your DTI is a percentage representing how much of your income is put towards paying down debts. Since a mortgage is such a large investment, and your monthly payments could be fairly substantial, underwriters want to make sure that you’ll be able to make those payments. So, the lower your DTI, the better.

In general, a DTI of 36% or lower is ideal. In fact, a DTI above 50% most likely won’t be approved (although there are exceptions).

To calculate your DTI, simply divide your monthly debts by your monthly gross income. If your resulting percentage is higher than 50%, you’ll want to work on paying off some of your debts.

Debt Management Tips

Whether you’d like to reduce your debt before buying a house or just want to maintain a solid credit score by making consistent credit payments, knowing how to manage your debt could help you qualify for a mortgage. And it can also reduce your own stress levels.

The following tips can help you manage debt before buying a house, and could also be helpful once you’ve purchased your dream home and are in the thick of making mortgage payments:

Look at Your Credit Report

Your credit health is an important qualifying factor for a mortgage. So, it can be a good idea to take a look at your credit report to ensure that everything has been reported correctly and that there aren’t any errors. You wouldn’t want your credit score to be negatively impacted because of mistakes in your credit report.

You can order your credit report from any of the three major credit bureaus: Equifax, Experian, and TransUnion using annualcreditreport.com. Or you can even get your free credit report card here on Credit.com.

Once you have your credit report it is important to look at the following:

• Your personal information
• Your credit accounts
• Credit inquiries

If you see any errors or inconsistencies anywhere in your credit report, these can be challenged with the credit bureau that created the report.

Consolidate Your Debt

If you find that you’re making payments on various loans and/or credit accounts, it could save you money (and save you from stress) to consolidate your debts into one. This way, you’re only paying interest on one debt instead of multiple. Therefore, you won’t have multiple payments to keep track of.

Related Read: What Is a Debt Consolidation Loan and How Can You Get One?

Don’t Make Drastic Changes to Your Credit

It can be tempting to pay off debts right before applying for a mortgage. However, doing so could actually hurt your credit score. When you pay off a debt, your credit score will actually drop temporarily.

On the flip side, if you’re trying to build credit and try to open multiple credit cards, or take on other debt before applying for a loan, this will also take a hit on your credit score. Not to mention that seeing a lot of change and new debt before applying for a mortgage is a red flag to underwriters. It can indicate you might not be financially prepared to take on a mortgage.

Make a Budget

Whenever a financial discussion is taking place, budgets are bound to come up. While the concept of making a budget might seem obvious and over-shared, it’s a great way to track your expenses and ensure that you’re meeting all your financial expectations and needs. There are a lot of costs involved with buying a house. So, you’ll want to make sure that you can afford them.

In this case, creating a budget can help you map out your current debts and other expenses in relation to your income. This allows you to see what’s happening and adjust as needed. A budget can give you the peace of mind that you’re not overspending, and are still able to meet all your other financial responsibilities.

Build Your Emergency Fund

Building your emergency fund before getting a mortgage may be one of the most important things you can do. You never know what expenses might arise once you purchase your house, and you don’t want all your money tied up in your mortgage payment and other monthly payments if, for example, your roof needs to be repaired or you encounter water damage.

It’s often encouraged to set aside three to six months worth of expenses in an emergency fund.

The Bottom Line

Buying a house is a big purchase, and it can be daunting to think of getting a mortgage if you are trying to pay down student loans, an auto loan, credit cards, etc. To help you save money and save you from stress, work on paying down other debts so you can be confident in your ability to make mortgage payments and enjoy your new home.

However, you don’t need to be debt-free to buy a house. In fact, some well-managed debt can boost your credit score, showing mortgage underwriters that you are a responsible borrower.

That doesn’t mean that you need to dig yourself into a hole of debt that you’ll never crawl out of. By taking the time to create a budget or analyze your credit report, you can see how you’re doing financially and where some changes can be made. Perhaps you could consolidate some of your existing debt, or you could completely pay off some of your debts. 

In the end, you just want to make sure that you’re comfortable taking on a mortgage and can afford to do so. 

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