Sometimes sound financial strategies can be counter-productive to borrowers in qualifying for a mortgage. I often have future home buyers ask me if they should payoff credit cards before purchasing a home. In many cases, this can actually disqualify the borrower(s) from qualifying for a mortgage.
Lenders qualify borrowers based on gross income and monthly debt obligations. Lenders consider two debt ratios. A house ratio is calculated by taking the actual mortgage payment and dividing by gross income. Total debt ratio adds other minimum debt payments to the mortgage payment and divides by gross income. As a general guideline, a mortgage payment should not exceed 28% of gross income, and total monthly debts including mortgage payment should not exceed 36% of gross income.
What counts as debt and income? Lenders consider guaranteed income or monthly gross income for W2 employee wage earners. A weekly salary and 40 hour work week are examples of income. Overtime, bonuses, and commission can be added as income, but only if applicant has a two year history. Self employed borrowers must provide two years of tax returns, and the net profit average will be considered as income. Lenders count monthly installment and revolving debt payments on a credit report including car payments, student loans, minimum credit card payments, and child support. For revolving debt, lenders count only the minimum monthly payment. Insurance payments, utility payments, living expenses, and voluntary 401K deductions are not deducted or considered in calculating debt ratios.
Let’s look at a sample scenario for a married couple. One spouse has a $35,000 yearly salary, and the other spouse makes $40,000. Total income is $75,000 per year, or $6,250 per month. Based on this scenario, the couple can afford a mortgage payment up to $1,750 per month (28%), and other monthly debt payments should not exceed $500 per month (36%).
Below is summary:
Gross Income- $6,250 X 28% = $1,750
Gross Income- $6,250 X 8% = $ 500
Total Debt Ratios- 36% = $2,250
In this situation, the lender allows $500 of monthly debt to be added to the mortgage payment. Let’s assume borrowers have a car payment of $300 and several credit cards with minimum payments adding up to $200. Allocating thousands of dollars to payoff the credit cards will not help the borrowers in this situation. In fact, it may exhaust the borrowers’ down payment and disqualify them from buying a home. If the borrowers purchase a home with a $1,500 mortgage payment, they can have up to $750 in other monthly debt payments. The total debt including mortgage should not exceed 36% of gross income, or $2,250 per month. If the borrowers have zero debt, they still are limited to the 28% house ratio or $1,750 per month. Paying off all debt does not increase the house ratio allowance.
Borrowers must put down a minimum of 3.5% when applying for an FHA mortgage and 5% for a conventional mortgage. Some loans also require borrowers to have 3-6 months reserves in addition to down payment, closing costs, and prepaid expenses. See my blog article regarding gifts and seller concessions.
As you can see, it is important to do your homework. It may be necessary to pay down debt to qualify for a mortgage. However, you must balance paying off debt and maintaining adequate funds for down payment, closing costs, and monthly reserves. In most circumstances, the seller can provide an allowance towards your closing costs and lenders will considered an IRA or 401K for monthly reserves, but only 60% of vested balance.
Make sure you don’t spend your down payment and reserves. If you have any questions, please call us at 512-257-9836. Our office provides sales, leasing, property management, and mortgage services.