It's not impossible to buy a home when you have existing debts. Home buyers do it every day, in fact. But you have to know how your existing debts are affecting your standing with the lender and the ways you may be able to exclude some debts from your loan approval process.
When you apply for a mortgage, the lender takes into consideration your credit score, the cash you plan to use on a home, your ability to pay back the loan, and the amount of expenses you have (including a proposed mortgage payment) against your monthly income. They're the four Cs of lending: credit, collateral, capital and capacity. Each play a key role in your ability to obtain a mortgage.
Liabilities, such as monthly payments on other loans, take away from your capacity to handle a mortgage payment. If all of your income is going toward debts (with or without a mortgage payment included), loan qualifying can quickly become very problematic. Installment loans typically carry the largest monthly payments and hurt your chances of qualifying the most.
Installment loans have a set payment schedule with the loan amount being repaid over time. The most common forms of installment loans include:
- car loans
- personal loans
Picture this scenario: You have a car loan with a monthly payment of $400 per month and there's just 12 months left on the loan. This will hurt your debt-to-income ratio when trying to qualify for a mortgage. This obligation will count against you in determining how much house you can buy or how much mortgage you can handle. The payment associated with this installment loan obligation is what the lender uses to determine how much or how little the liability affects your borrowing power.
That $400 per month may seem small to you, but it can sway purchasing power by as much as $40,000 depending on the terms of the mortgage, so it does matter! If you have just nine months left on the obligation, this is where the wheels begin to turn and more leniencies may be granted with conventional financing, however.
How to get a loan excluded from your debt-to-income ratio
An installment loan with less than 10 months of payments due may be omitted from the debt-to-income ratio on a case-by-case basis. Your overall financial strength determines whether your lender will exclude the loan. Case in point, if a borrower had an installment loan payment as high as 25% of their income, before the housing payment is calculated, that would almost certainly cause the lender to take a more conservative approach and include the liability in the debt-to-income ratio even if there are less than 10 months of payments left on the loan.
An additional factor the lender will look at would be the amount of reserves the borrower has after the fact. If, for example, this borrower had an entire year of income in savings, that's called a compensating factor. That factor may potentially allow a loan approval with an installment loan of less than 10 months, even if the payment is relatively high compared to the mortgage payment.
Does this loophole work for FHA loans?
Conventional loans are different beasts than Federal Housing Administration (FHA) loans. For an FHA loan, all liabilities must be included in the borrower's debt-to-income ratio with one exception. Installment loans can be omitted from the debt-to-income ratio if the obligations will be paid off within 10 months, and the cumulative payments of all such debts are less than or equal to 5% of the borrowers gross monthly income.
So, for example, if you took out a personal loan awhile back to consolidate some credit card debt, and your monthly payment on that loan is $100 and will be fully paid off in nine months, you would need to make at least $2,000 a month in gross income in order to be able to have this liability excluded from the debt-to-income calculation.
Before you apply
How do you decide which mortgage loan program makes the most sense if you're trying to qualify for the maximum amount of affordable house? A mortgage professional should be able to guide you through conventional, FHA and any other loan programs you may qualify for and help pick the right one for your situation.
But before you apply for a loan, be sure to look over those four Cs of lending: credit, collateral, capital and capacity. Review your free annual credit reports at AnnualCreditReport.com to spot any errors that may be bringing down your credit scores. (You can also check your credit scores for free on Credit.com every 30 days to see where you stand.) And start thinking about your down payment, debts and income to determine how much house you can afford.
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