With home prices (and interest rates) on the rise, it’s getting more and more difficult to qualify for a mortgage. One simple strategy you can employ to boost your purchasing power is to pay down existing debts.
I’ve already warned prospective mortgage applicants to avoid swiping their credit cards before and during the mortgage process, but this approach goes a step further.
Less Debt = Lower DTI
- While a higher income is great
- It might not mean much if you have a ton of expenses
- If you can keep your debt to a minimum
- More of your income can be used to qualify for a home loan
Put simply, if you have less debt, your debt-to-income ratio will be lower, even if your income doesn’t rise.
For example, if you’ve got $2,000 in monthly debts and $10,000 in monthly income, your DTI is 20%. Lower that monthly debt down to $1,000 and you’ve got a DTI ratio of 10%.
Once we add the proposed housing payment into the mix, your DTI will shoot up to account for that new monthly obligation, so it’s important to ensure you’ve got “room” to take on a new mortgage.
If you’ve already got lots of existing debt that is reported on your credit report, and not much income, it’ll be difficult to qualify for a large mortgage and stay below key lender thresholds, such as the 43% max DTI ratio for Qualified Mortgages.
Say you’ve got a slew of credit cards with balances on them. If the minimum payments on all the cards amount to $500 or more each month, you’re hurting your mortgage purchasing power because those pesky debts are limiting what you can afford.
For the record, this can hurt you whether you pay them off in full or not – if there happens to be a large balance at the time when the lender pulls your credit report, the elevated minimum payments can still count against you.
To avoid this, you can stop charging entirely when you begin house hunting. Just leave the credit cards at home and start using your debit card instead for all new purchases.
Or, bring a checkbook and amaze Millennials everywhere you go. It’s actually pretty fun to see their bewilderment when you ask if their establishment accept checks.
$100,000 Mortgage = $500 a Month
- If you eliminate $500 in monthly debt
- Say by paying off a car loan/lease
- Or a credit card, student loan, etc.
- You’ll have another $100,000 in home purchasing power at prevailing rates
If you whip out a mortgage amortization calculator, you’ll quickly discover that $100,000 borrowed at 4.25% (this is roughly the going rate for a 30-year fixed today) will set you back about $500 each month. It’s $491.94 to be exact, but you get the idea.
By eliminating $500 in existing monthly debt payments you could increase your purchasing power by $100,000. Put another way, doing so would allow you to buy another $100,000 in house. And let’s face it, you’ll probably want/need more house these days with prices reaching new all-time highs.
The caveat here is that you need to be asset-rich to employ this strategy, or at least have some excess reserves on hand to pay down these debts, while still leaving money aside for down payment, closing costs, etc.
Obviously as your purchase price rises, the down payment requirement rises. So if you do decide to buy more house after paying off some other debt, make sure you account for down payment, insurance, property taxes, etc.
Bonus: Credit Score Boost!
- Paying down debt will offer another advantage
- Your credit scores should rise as a result
- And assuming they do increase
- You might be able to obtain a lower interest rate, further boosting your purchasing power
Assuming you can muster paying down (or completely off) some existing debts, and avoiding new ones, you should get a nice little credit score boost in the process.
As I illustrated in my post about avoiding swiping before the mortgage, my own credit score plummeted nearly 70 points simply because I went on a little spending spree. But once I paid off the temporary debt, which I never actually carried month-to-month, my credit score shot back to new heights.
If you’re able to pay off credit card debt, student loans, auto loans, etc., your credit scores should benefit as well. How much so will depend on your overall credit profile, available credit, and so on, but a higher credit score generally translates to a lower mortgage rate.
That lower mortgage rate will also boost your purchasing power because it’ll equate to a lower housing payment each month.
So you actually benefit twice here.
Read more: Six ways to lower your mortgage rate.