With dozens of “free credit score” sites spamming away at potential first-time buyers, by the time they get serious about buying a home, most already know a lot about their credit histories and hopefully have taken steps to improve them.
Debt, however, is another story. The fact that high levels of debt are a potential barrier to getting a mortgage seems to be a mystery to many. Too much debt may be keeping more first-time buyers from getting financing rather than low credit scores — especially young adults with student loan debt.
The ratio of debt to income, or DTI, is one of the three primary factors lenders use to approve a loan application. The two others are credit as measured by FICO scores and the loan-to-value ratio, which isn’t known until the house gets appraised. Lenders can adjust for the latter two factors by increasing interest rates on a marginal FICO or by limiting the amount they will lend based on their appraisal, which forces buyers to come up with larger down payments or to convince the seller to sell for less.
Existing debt might be even more important than the other two factors because of what it says about an applicant’s ability to repay a loan. If a household’s gross income is $100,000 a year, or $8,333 a month, and they are making recurring monthly debt payments of $3,000 a month, they have a DTI of 36 percent. They are very close to the cutoff point for most lenders today.
Monthly debt payments include credit cards, installment plans, alimony, child support, auto loans, back taxes, property taxes, rent, student loan debt and personal loan debt. Not included are utilities, health and life insurance, groceries, cable, gas or other living expenses.
If the DTI is too high, there’s no quick fix, nor does the lender have any flexibility to reward a borrower who might have a great FICO score or a job with great future-earnings potential. The reason is the qualified mortgage (QM) rule, which took effect last year for conventional loans. This regulation set a cutoff point of 43 percent. Lenders try to stay below that amount by giving themselves a small cushion. Today, the median DTI that lenders are approving for all qualified mortgages is 37 percent — monthly debt payments equal 37 percent of borrowers’ monthly gross income.
The QM rule does not apply to the Federal Housing Administration (FHA), which has its own version of the rule that does not specify a DTI cutoff point. As a result, the median for an FHA application to purchase a home today is a little higher at 41 percent. If your mortgage doesn’t meet the standards for qualification, most lenders will reject you, and those that don’t will charge a much higher interest rate.
There are only two ways to improve, or reduce, your DTI. Either make more money or get rid of enough debt to bring your DTI to an acceptable level — at least 40 percent on an FHA loan or 35 percent on a conventional loan — or both. Unless you take a second job or have a raise coming, reducing debt is the easiest and fastest option.
Here are five sure-fire ways for your clients to reduce debt and reach an acceptable DTI:
1. Become debt-conscious.
Most people today have a better idea where they stand regarding the credit that is available to them than the debt that they owe. Weighing yourself regularly is a good way to start a diet by making you aware of what you eat. In the same way, start a “debt diet” by signing up for a “wallet”-type program through your bank or a personal finance website to monitor your debt on a daily basis. Take it a day at a time, and remind yourself that once you have purchased your dream home, you can relax a little.
2. Pay off small balances.
If you have several of these, they add up and increase your monthly debt load. DTI is figured on the basis of monthly debt payments, so if you can pay off debts with small balances you can materially reduce your monthly payment obligations. Even if you owe a small amount on a credit card, you must pay a minimum monthly amount. Pay off small balances before large ones to get your monthly debt load down quickly. Close or reduce lines of credit that you don’t need.
3. Reduce interest and consolidate monthly payments.
Chances are you are not getting great interest rates on some of your credit cards and installment plans. Many consumer lenders have “teaser” rates that dramatically reduce the interest you will pay. Use one of these to consolidate your debt and pay off several high-interest cards. You will also lower your monthly payments by consolidating and refinancing your debt, including student debt and automobile loans, with the lowest-interest personal loan or credit card you can find.
4. Stop buying on credit.
Trying living for a week without buying anything with plastic. Living on a cash-only basis makes you very aware of every penny you spend. Forgo a snack, read news online instead of buying a newspaper, shop a little for the cheapest gas and cook meals instead of eating out. It’s amazing how much you can save.
Estimate your savings on a daily basis and put aside that amount in a savings account. Two good things will happen. You’ll have more cash to pay off debts, and your debt obligations won’t increase. Once you have reduced your debt, do not buy anything large on credit until after you close. More than one lender has pulled a borrower’s credit the day before closing and reduced the loan amount if the DTI has increased.
5. Start with FHA.
Because FHA funds applications with lower FICO scores and higher DTIs than conventional loans, your chances are better with FHA if you have a DTI above 30 percent. Of course, FHA also requires small down payments, but the recent reduction in annual mortgage insurance premiums makes FHA even more attractive.
For many young buyers, getting their debt reduced takes time. That’s one reason the median age of first-time buyers has been creeping up into upper 30s and 40s in recent years, despite soaring rents. With age comes higher income levels, better credit histories, cash for down payments and lower DTIs, if not necessarily lower levels of debt.
Steve Cook is editor and co-publisher of Real Estate Economy Watch and provides communications consulting services to leading real estate organizations. Visit him on LinkedIn and Facebook.