Lenders are beefing up their lending standards, meaning that if you have outstanding debt, you may have to pay that off before getting a mortgage.
What it boils down to is this: if you can afford to pay cash for a home, a mortgage lender will undoubtedly approve you for a loan. But if you can't afford to pay cash for your next property purchase, you've got to get your finances in home-buying shape. A big part of that is getting your debt-to-income ratio down to something that lenders will approve.
Carrying too much revolving and installment debt (like a car loan) will eat into your debt-to-income ratio, and a lender will subtract the amount you're paying to service your debt each month from the amount you have available to pay for a mortgage, real estate property taxes, and your required homeowner's insurance policy.
Lenders are so picky about who they'll lend to these days that they'll seize on an out-of-whack debt-to-income ratio as a reason to reject your loan application. Instead of facing that unpleasant prospect, follow these steps to get rid of your debt before buying a home:
- Calculate what you owe. If you have a handful of credit cards, plus a car loan, student loans, and maybe a gas card or two, it’s easy to lose track of your debts. Make a list of everything you owe, along with the interest rates you’re paying.
- Figure out how much it costs for you to live. Write down everything you spend each week, month, and year. Then pare your expenses down to the basics and figure out how much you’ll save. After that, you can determine how much of that savings you can apply toward paying down your debts.
- Pay off the highest-interest-rate loan first. The savviest move you can make is to focus all of your energy on paying down the debt with the highest interest rate first. Since every dollar you prepay on a loan (credit card, mortgage, school loan, etc.) effectively earns you that interest rate as a return on your investment, the higher the interest rate on the debt, the more you’re earning on your money. For example, if your credit card debt is at 15 percent, every dollar you prepay is earning you 15 percent. So get moving.
- Pay down a small debt. If your biggest debt has the highest interest rate but you’re also carrying a relatively small debt on another credit card, consider paying that debt off quickly. That will give you a psychological boost and provide you with another source of funds to use to pay down the larger debt.
- Don’t cancel your credit cards after paying them off. You’ll want to keep your maximum available credit limit as high as possible to help boost your credit history and credit score. So pay off the debts, but leave the lines of credit open.
You don’t have to pay down all of your debts in order to qualify for a home loan. But the more you pay down, the more you’ll be able to spend on your next home.
For more information on how to manage your debt before buying a home, read my Equifax blog post:
Ilyce Glink is the author of several books, including 100 Questions Every First-Time Home Buyer Should Ask and Buy, Close, Move In!. She blogs about money and real estate at ThinkGlink.com, The Equifax Personal Finance Blogand CBS Moneywatch She is Chief Content Strategist at RealtyJoin.com, a community for real estate investor