By Credit.com | posted Sep 11th 2013 12:41PM
By Scott Sheldon
Trying to secure a mortgage right now? From higher mortgage rates, to rising home prices to the contraction in buying power — securing financing, for some, can be no easy endeavor. As prices, and rates rise simultaneously, lenders will still place the weighted emphasis on "real income," or, the amount of monthly payment you can afford — as that's what the loan is truly made against. Unfortunately, the amount of debt you have effectively chips away at your "real income." So before you try to get a mortgage, you might want to pay down your debt. Just make sure you do it the right way.
Before I delve into the specifics, here are some quick terms you need to know:
• Debt to income ratio, or DTI: Represents the total amount of monthly debt payment (including the house payment) divided into monthly income. Whenever this number exceeds 45 percent of the gross monthly income, things get tricky.
• Real Income: Also known as "qualifiable income," the net income considered for the housing payment after present liabilities are factored in. If you have $5,000 in monthly income × 0.45, that gives you $2,250 as a total debt allowance. If your other debts total $250 per month, that means your real income is $2,000 per month. Real income is also equivalent to a proposed housing payment.
• Debt: Refers specifically to the minimum payment obligations the consumer is responsible for. This has nothing to do with the total amount of debt, but what the monthly payments are. Lenders are looking for cash flow, how much or how little of it there is. Tip: Debt erodes income (ability to borrow money) at a ratio of 2 to 1; it takes $2 of income to offset $1 of debt.
Now, the strategy for paying off debt to qualify differs when buying a house from refinancing. Let's look at the differences:
Paying Off Debt When Buying a Home: When buying a home, and prior to attaining an accepted purchase offer, paying off debt to qualify is simply a function of learning how much more buying power is achievable by eliminating debt like credit cards, student loans or car loans. A qualified mortgage lender can run "what if" possibilities, which could become crucial in your endeavor to purchase not only the right home, but ultimately the home you can afford.
Let's say there's $5,000 left on your car loan, you have the cash in the bank and the car loan payment is $600 per month. $600 per month on a car loan reduces your ability to purchase to the tune of more than $100,000 in loan amount. Consider this: A $100,000 mortgage loan at 4.5 percent on a 30-year fixed rate mortgage translates to $506 per month, $94 per month less than if you didn't have the debt. If you pay off the debt in full, your DTI is reduced, improving your ability to qualify and increasing your real income.
How to Pay Off the Debt and Still Meet the Lending Credit Standard: If you're paying it off pre-contract, simply inform your mortgage company and they can do a third-party validation and the debt can be omitted. When paying off during the escrow process, monies will have to be sourced and paper trailed, which is a little more technical, but still achievable. The same goes for credit cards and other payment obligations.
Paying Off Debt When Refinancing: When you're refinancing, the lender's going to require that your credit obligations — such as a car loan or credit card — are paid off in full and closed to prevent the possibility of your accumulating further debt, thus potentially affecting your ability to repay in the future. Moreover, the lender would call for an escrow account to pay off the debt through the loan closing. When it comes to paying off debt to qualify in refinancing, different lenders will vary on their specific approaches. Generally, though, the accounts will have to be closed as well. That won't prevent you from reapplying for credit after the mortgage has closed, however.
How to Pay Off the Debt and Still Meet the Lending Credit Standard: The monies you use to pay off your debt, similar to a purchase transaction, will have to be sourced — and you'll have to have proof that the obligation has been closed. If possible, pay the credit card in full, learn the date the creditor reports to the bureaus, then apply for the mortgage after the creditor has reported it to the bureaus. Doing this will show the updated balance on the credit report, which will improve real income (revealing less debt), making the process more streamlined.
If you have debt that otherwise could be eliminated and have the means to pay off the debt, strongly consider doing so, as higher credit risk mortgages tend to be more pricey overall — compared to those for borrowers with lower debt-to-income ratios and better credit scores.
As you get ready to buy a house or refinance your mortgage, it's important to pull your credit reports and credit scores to see where you stand. You can get your credit reports for free once a year from each of the three credit reporting agencies, and you can monitor your credit score using a free tool like Credit.com's Credit Report Card.