Having outstanding debt when applying for a mortgage is definitely a tough place to be in.
While being in debt can definitely hurt your chances of securing a mortgage, it doesn’t make it impossible to secure one.
The amount of debt you have can also play a huge role in whether or not you’ll be able to get your mortgage approved.
Today, I’ll be looking at how much debt could be too much debt when applying for a mortgage.
What Do Mortgage Lenders Look at When Reviewing a Mortgage Application?
I’ve gone over multiple times about what lenders look at when reviewing mortgaging applications.
Your credit history is looked at along with your income, your monthly expenditures, the value of your property as well the amount of money you want to borrow.
The amount of money you can borrow depends highly on what you can afford. This is why mortgage lenders perform affordability assessments.
These assessments help them get a better idea of what you will be able to afford as your mortgage monthly payments.
Hence, they will only approve you for a mortgage they think you’ll be able to afford comfortably.
This means that if you have outstanding debt and most of your income is going towards taking care of that debt, then you may not be able to borrow a lot of money from your mortgage.
What is My Debt-to-Income Ratio?
Your debt-to-income (DTI) ratio is a financial measure which estimates what your debts are compared to how much you earn every month.
It’s something that mortgage providers use when reviewing mortgage applications.
Obviously, lenders will try and look for applicants that have a lower debt-to-income ratio because they believe that they will be able to manage their monthly payments more effectively.
Please note that while your credit utilisation rate does have an effect on your credit score, it does not have an effect on your DTI ratio.
If your DTI ratio is high, it’s usually a good idea to devote a few months to lowering it before getting a mortgage.
A low DTI ratio indicates to a lender that you practice good financial discipline and don’t have a hard time balancing your debts with your income. The lower your percentage is, the better your chances will be in securing any line of credit you want including a mortgage.
On the other hand, a high DTI ratio indicates to a lender that you currently have too much outstanding debt compared to your income. This will suggest to them that you’ll have a lot of trouble making any additional monthly payments and thus, your chances of securing a mortgage would be very low.
You may still be able to secure a mortgage with a high DTI ratio but you’ll have to convince your mortgage provider with a detailed plan as to how you intend to make your monthly payments.
How Do I Calculate My Debt-to-Income Ratio?
Calculating your DTI ratio is fairly simple.
Firstly, you must add up any debt payments that you make every month. This may include student loans, credit card loans, child support, car loans, etc.
Secondly, you must add up your gross monthly income. This includes not only your salary but any other form of income you may have such as from investments or rented properties, etc.
Keep in mind that you should NOT subtract any taxes or other deductions from your monthly income when calculating your DTI ratio.
Then, all you have to do is divide your total debt payments with your total monthly income.
Here’s an example for you:
Suppose that you pay £400 each month towards your car loan and £400 towards your credit card debt. Then, your total debt payments would be:
£400 + £400 = £800.
Now, suppose that your gross monthly income is £4000. Then, your DTI ratio would be 20% (800/4000 = 0.2). Keep in mind that the DTI ratio is typically expressed as a percentage.
What do Lenders Consider to be a Good DTI Ratio?
As I mentioned earlier, when you apply for a mortgage, your mortgage provider will assess your financial situation.
This will include assessing your credit history as well as asking you about any other debts you may have such as credit card debt.
Your DTI ratio is also something that they will calculate and use in order to judge whether or not they should approve your application for a mortgage loan or not.
Keep in mind that you will have to provide complete proof in the form of bank statements during your mortgage application process.
They will be used to prove what your gross monthly income is as well as the payments you make towards your debts such as credit card debt, student loans, car loans, etc.
Once the lender has complete information about your finances, they will calculate your DTI ratio for themselves.
Most mortgage providers prefer to see a DTI ratio of less than 36%. Of this 36%, no more than 28% should be going towards your monthly mortgage payments.
This would mean that, for example, if you had a gross monthly income of £4000, then your mortgage payments should not exceed £1120.
For most lenders, if your total DTI ratio exceeds 36%, it will be quite difficult for you to get a mortgage.
You may still be able to get it if you can explain to the lender why you’ve accumulated so much debt and if you have an effective plan in place to address it.
If your DTI ratio is higher than 43%, it’s likely that you will not qualify for a mortgage loan no matter what you do.
What can I Do to Lower My Debt-to-Income Ratio?
We just discussed how to calculate your DTI ratio above.
Using that information, we can see that there are mainly two ways to lower your DTI ratio:
- By lowering your debts.
- By increasing your gross monthly income.
Reducing your debts can go a long way in lowering your DTI but that’s easier said than done.
If you have credit card debt, you may be able to reduce it by transferring your balance onto another credit card that has a lower interest rate.
Balance transfer on credit cards can be a very prudent way to effectively reduce the amount of debt you have.
However, you must keep in mind that balance transfers on credit cards often have their own fees which you should be wary of.
You can also opt to reduce your living costs by assessing your spending habits and eliminating any unnecessary costs.
You should consider your needs versus your wants and try to hold off on your wants until you can get your finances in order.
After a few months of practicing financial discipline, you will find that you will definitely have some extra money freed up. You can then use this money to take care of your debts and thus, lower your DTI ratio.
In order to increase the amount of money you earn every month, you can opt for any of the following:
- Get a second job or try freelancing.
- Work overtime at your main job.
- Ask your employer for a pay raise.
- Learn a skill or complete a course which will enable you to secure a job at a higher salary.
Having debt when applying for a mortgage can definitely be overwhelming.
However, if you know how mortgage providers perform their assessments, you can definitely secure a mortgage loan for yourself despite having outstanding debt.