Do you carry debt and worry that it may stop you from buying a home someday? Well, you’re not alone.
“An alarming 35 percent of people with credit files have debt in collections,” according to a July 2014 report by the Urban Institute, a nonprofit organization that conducts research on social and economic policy.
If you’re in that group, it’s important to know how that will affect your ability to get a mortgage and even more importantly, what you can do to lessen the impact.
And even if you don’t find yourself behind in your debt payments, keep reading to find out how exactly your credit and payment history affect your ability to qualify for a mortgage.
If I Have a Delinquency or Bankruptcy, Can I Still Get a Mortgage?
It’s not news that being in poor standing with creditors or having the B-word associated with your finances will hurt your ability to get a mortgage. But the details do matter.
First, being behind on payments and placed in collections for anything from credit card debt to medical bills or having a bankruptcy will hurt your chances at qualifying for a mortgage.
“Simply put, banks are trying to determine whether or not you will pay them back. If your credit history shows evidence of irresponsibility or an inability to manage your finances, you aren’t a good bet for a bank,” says Ken Lin, CEO of CreditKarma.com, a site where consumers can access their free credit reports.
In addition to looking bad, a delinquency or bankruptcy can lower your credit score, which lenders use to determine your eligibility and the interest rate they’ll offer you, Lin says. That’s because a delinquency is when you are behind in your credit card or other loan payments – exactly what lenders are trying to make sure you avoid with them.
A bankruptcy is much more serious and a little more complicated, says Lin. Basically, it is a legal proceeding in which you declare that you are unable to pay your debts and need a “fresh start,” he explains.
However, your creditors do get a portion of what you owe them from any assets you may have, says Lin. Obviously, that will worry potential future lenders, he adds.
According to Lin, most lenders use your FICO score, which runs from 300 to 850, and the higher the better.
To get the best interest rates on a mortgage, you’ll want a score of 760 or above, according to FICO’s website. To qualify for a mortgage, even at a higher interest rate, you’ll want at least a score of 620 to 640, says Lin.
A bankruptcy and the delinquencies that lead to it can really take a toll on your score, says Lin. A delinquency and bankruptcy will stay on your credit report and hurt your score for seven years, he says.
“The amount will seem diminutive, though, because the actual bankruptcy itself only lowers your score by about 50 to 150 points, which might not seem like that much,” says Lin.
But don’t let that fool you. Bankruptcy is merely the final blow to your credit report after what was surely a long and damaging road, says Lin.
On the road to bankruptcy, you’ll have gone through being 30 days delinquent on payments, then 60 days, then 90, and so on, explains Lin. As that happens, your score gets hammered down for months or years. Hence, by the time you file for bankruptcy, you’re not going from 800 to 700 – likely you’re going from 600 to 500 and now can’t qualify for any mortgage, he says.
“There may be opportunities out there to get a mortgage without good credit, however potential buyers need to be careful. Those mortgage structures and rates may defeat the purpose of the mortgage, and you may end up paying a lot more for your house than you should,” he says.
Does My Credit Limit Matter?
According to Lin, there’s a commonly spread myth that if you have too high a credit limit – even if your outstanding balance is low – lenders don’t like it.
“The convention was if you’ve got all of this available credit it’s a little bit like a loaded shotgun, right? You might go off at any point in time and buy a whole bunch of stuff [and get into debt]. But what the statistics show and what the credit scoring companies have disclosed is that is not the case,” says Lin.
In fact, he says having a high limit can be a good thing, if you’ve handled it well.
“Say you’ve had $30,000 worth of credit for the last 20 years, and you’ve never abused that. How else could you attest to a better credit situation than someone who knows how to manage that much money for that period of time?” says Lin.
And mortgage lenders see that logic, he says. So Lin says don’t worry too much about your limit – worry instead about how well you’re managing it.
How Much Credit Card Debt Can I Have and Still Qualify?
This is actually a tricky question since the answer might vary greatly from person to person, depending on other factors, such as the home you want to buy, other types of debt, and your payment history, says Lin.
However, there are some general rules you may want to live by, such as the rule of 30 percent. In a nutshell, Lin says data shows that once your outstanding balance goes above 30 percent of your available credit, it can start to adversely affect your credit score, and therefore your ability to get a mortgage.
“If you go over [30 percent] for a short time – a month or so – a few times, that’s okay as long as you pay your balance down,” says Lin. But you shouldn’t go over 30 percent regularly, and especially when a lender is about to check your credit, he says.
So, for example, if you have a $1,000 credit limit, try to keep your outstanding balance below $300. For a $2,000 limit, the target number is $600, and so on.
But as we all know, life has a funny way of making us use credit – for everything from medical emergencies and car repairs to big screen TVs and big nights out. But fret not, because if you do go over 30 percent and can’t pay your balance down, there is an alternative: increase your credit limit.
There is one caveat to this “solution,” however, says Lin. The larger outstanding balance will likely result in a higher monthly credit card payment, which could adversely affect your chances at securing a mortgage by contributing to your overall debt.
How Do Student Loans, Car Loans, and Other Debt Factor In?
The short answer is that they factor in heavily. But there is actually a way to figure out how much – your debt-to-income ratio (DTI). It is simply the percentage of your gross monthly income that goes toward paying for your debt (credit card, car, and student loan payments, etc.). Food, gas, and incidentals are not included, but the monthly payment and taxes on your potential mortgage are. Ideally, your DTI should be 40 percent or lower, says Lin.
Every mortgage lender has a keen eye on your DTI, says Ellen Davis, a senior mortgage banker with Corridor Mortgage Group in Columbia, Maryland. In fact, Davis says your DTI is usually much more important than the type of debt you carry.
So, say your total debt obligations for credit cards, car and personal loans, and the mortgage for which you’re applying came to $1,500 a month. Your gross monthly income would have to be at least $3,750, making your DTI an acceptable 40 percent.
Your DTI is one important number that lenders use to decide not only if you qualify for a mortgage, but for other things such as how much they can safely lend you and at what interest rate, says Davis. Additionally, they use your DTI to determine how large your monthly payment can be.
It’s also an important number for you, says Lin, because, like the bank, you want to know that you can afford your dream house without it becoming a huge financial burden on you.
A Few Final Tips
Courtesy of Lin, here are some useful tips on credit, whether you land on the higher or lower end of the credit score range.
• Know your credit score and credit record, and if there are errors, dispute them. According to Lin, one in four credit reports have a meaningful error.
• If you’re not happy with your score, identify why it’s low. It could be due to any combination of the following: your payment history, your credit utilization, new credit cards (and applications), and the length of your credit history.
• Keep credit card balances to 30 percent or less of your available credit.
• Avoid applying for new credit cards more than once a year – credit checks can negatively affect your score.
• Keep and responsibly use up to three credit cards by paying on time and avoiding maxing out your cards. This establishes your credit and shows that you can manage credit responsibly.
• If your score is lower because you are younger and haven’t established credit, consider opening a secured credit card to start building credit. This is a credit card that has a limit that is a percentage of or equal to an amount of cash you place in an account, such as an interest-bearing savings account.