When you buy a house, a big part of a lender’s decision whether to approve your mortgage rests on whether or not you can afford it. If you have a lot of debt, the monthly payments on those obligations chip away at the total amount you can pay each month on a mortgage.
But that doesn’t mean it’s impossible to buy a house if you’re in debt. It’s just a bit more challenging. If you want to stop paying rent and enter the exciting world of homeownership, here’s how you can pay off debt to buy a house.
1. Calculate your debt-to-income ratio
Your debt-to-income ratio, often called DTI ratio, is a measurement that compares the amount of debt you have to your income. It helps determine how much you can actually afford when it comes to mortgage payments.
How much debt can you have and still qualify for a mortgage?
Most lenders won’t approve you if your DTI is higher than around 43%.
For example, let’s say you make $52,000 a year. This means your gross income each month is around $4,333. If half your paycheck is devoted to paying off debts, then about $2,166 of your income goes toward paying off your various debts.
By these numbers, your DTI would be 50%. The bank would probably not approve you for a mortgage since your DTI is higher than the maximum 43%. To fix this problem, you can do one of two things: start making more money and/or lower your monthly recurring debt payments.
2. Find ways to decrease your debt
Qualifying for a mortgage partially depends on what part of your monthly gross income is paid toward the minimum amount due on recurring bills. These might include credit card bills, student loan payments, car loans and other payments. Consolidating can be a way to reduce that amount.
What does consolidating mean? Consider an example where you have five credit card payments each month. Consolidating them means that instead of making five separate payments to individual lenders, you make one payment each month.
If your credit is good enough, you may be able to get a consolidation loan with better terms. That means your one consolidated payment may be lower than the five payments combined. You can consolidate student loans, too, and get the same potential benefits.
After you’ve consolidated, you can recalculate your DTI ratio. If it’s lower, you may fall below the DTI threshold required to be approved for a mortgage.
Pay off or pay down some debt
If you make an effort to pay off or pay down some of your existing debt, this can help decrease your DTI ratio and make your financial picture look more favorable to lenders. It may be best to concentrate on paying off recurring debts, such as credit cards, to help your chances.
Is it best to pay off debt before buying a house?
There’s no one right answer to this question. It can depend on your mortgage lender. Your mortgage lender may want you to pay off debt before making a down payment while others may be OK with your DTI and want a larger down payment. If you’re under the 43% DTI and have a good credit history, you might consider working with a mortgage lender to find out what your options are.
If any debts listed on your credit report aren’t yours, this could be hurting your overall financial health. Make sure to closely examine the details of your credit report and make sure the accounts listed are actually ones you’re responsible for. If you do notice errors on your credit report, you can work to repair your credit by disputing the entries.
3. Find ways to increase your income
One of the ways to make your DTI more favorable is to increase your income. You can usually do this by either getting a better paying job or by getting a second job if you have the means. If you’re married and are applying for a mortgage with your joint income, perhaps your spouse can get a job to help increase their income. One drawback to this solution is that it’s a long-term solution and not a short-term one. Getting a new job, whether primary or secondary, takes time and effort.
4. Consider making a bigger down payment
Contrary to popular belief, a 20% down payment on a home isn’t required in many cases. FHA loans, for instance, only require 3.5% down, and some mortgage lenders may only ask for 5% down on a conventional loan.
However, keep in mind that the more you put down upfront, the less your monthly payments are and the lower your interest rate is likely to be. If you can put more money down, it makes the mortgage more affordable. If you’re hovering at the higher end of an acceptable DTI ratio, that may make a difference.
Looking at the big picture
When you’re ready to buy a house, it’s important to consider your level of debt, how much money you have coming in and your job security. If you’re able to consolidate your debt and get lower monthly payments as a result, your job is well-paying and seems secure and your credit is excellent, you can probably buy a home even if you have other debts.
Assess the risks
Remember that just because you might qualify for a home loan doesn’t mean you should buy a house. Stretching your limits to meet that 43% DTI ratio can be risky unless you foresee your income continuing to rise or you know any debt obligations you have are set to be paid off in the future.
Can paying off debt hurt my credit score?
Most of the time, paying off debt has a neutral or positive impact to your credit score. First, you decrease your credit utilization, which accounts for 30% of your credit score. A lower credit utilization can bring up your score. Second, you show the lender that you have the means to pay off debts, which can be a positive factor in whether you’re approved.
However, in a few cases, paying off debt could lower your score. If you pay off old accounts, you could change the age of your credit. How old your accounts are play a role in your score. You could also reduce your credit mix, which also factors into your score.
Neither of these factors plays as large a role as credit utilization, though. And if your mortgage company wants to see you with less outstanding debt, a tiny and temporary hit to your credit score may be worth getting approved for a loan.
This article originally appeared on Credit.com.