How Much Credit Card Debt is Okay When Buying a Home?
The following is for informational purposes only and is not intended as credit repair.
So, you’re thinking of buying a home, but you have some credit card debt. How will that debt affect your mortgage application process? There are a few things you’ll want to consider before filling out your first application that can make the process a little easier.
Your Debt-to-Income Ratio is What Really Matters
The first thing you need to know is your debt-to-income ratio. This is your monthly debt payments (all of them) divided by your gross monthly income. It's one of the key number lenders will use to determine your ability to manage your monthly payments. A 45% debt ratio is about the highest ratio you can have and still qualify for a mortgage.
Based on your debt-to-income ratio, you can now determine what kind of mortgage will be best for you.
- FHA loans usually require your debt ratio to be 45 percent or less.
- USDA loans require a debt ratio of 43 percent or less.
- Conventional Home Mortgages usually require a debt ratio of 45 percent or less.
It's Not the Debt, It's the Risk
In any situation when a financial institution is considering giving you money, it all comes down to risk. How likely is it that you're going to pay that money back? If you've already got a lot of debt that could make it more difficult for you keep up with new loans or lines of credit. It's all part of the complicated calculations lenders need to make when considering your application.
When applying for a mortgage, lenders will look at your application with three priorities:
- Debt-to-income ratio
- Credit score
- Assets (if you need them for a down payment)
Your unsecured debt (credit card debt) plays a big role in how much a lender is willing to write a mortgage for. If your unsecured debt is $250 a month, it could reduce your potential purchase price by approximately $50,000. $500 a month could reduce your potential purchase price by around $100,000.
In other words, you can have unsecured debt, but the more unsecured debt you have, the less a lender may be willing you give you to buy your new home.
Take Steps to Improve Your Odds with Lenders
To improve your chances of getting a mortgage, or even just getting a better interest rate, there are a few things you can do.
- Increase your income with a second job or home-based business (this will improve your debt-to-income ratio)
- Reduce your purchase price (that is, look for less house)
- Reduce or eliminate your monthly debt before applying for a loan
- Refinance your debt at a lower interest rate
A lender may even ask you to roll your debt into your mortgage. This will reduce your overall debt-to-income ratio and possibly even lower your interest rate, but keep mind that your new home will now be collateral for that debt and defaulting on it could mean foreclosure. If a lender does ask you to do this, you may want to take some time to think about it and determine if you can hold off on getting a mortgage until you’ve paid down your debt.
One last factor to keep in mind is your credit-utilization ratio; mortgage companies will look at this too and it will be part of your credit score. Essentially it means the amount of available credit you have compared to what you owe. For instance, if one of your credit cards has a $10,000 limit and you only owe $500, you have $9,500 in credit available to you that you’re not using. Mortgage companies like that. But if you owe $9,500 on that same credit card account, you have a poor credit-utilization ratio and it will lower your credit score and your chances for a mortgage.
When it comes to applying for a mortgage, some credit card debt is good, it shows you have credit and use it well. But too much credit card debt is bad because it shows you may not be responsible with your debt, which suggests you may struggle with your mortgage payments. Determine your debt-to-income ratio, review your credit score, and reduce your debt as much as possible before applying for a mortgage in order to get the best interest rate and guarantee approval. If you need one-on-one help understanding your debts and setting a plan to reduce them quickly, consider speaking with a debt and budget counselor. Counseling is free and available 24/7.
Article updated July 2020