In an ideal world, you’d begin your homeownership journey debt free (with a 3-month emergency fund saved, to boot). In the real world, however, debt is a reality, whether it be some credit card debt, a car loan, or outstanding student loans, all of which could add up to a sizable amount. Therefore, removing it before buying a home may be all but impossible.
The good news is that homeownership may still be an achievable goal, even if you’re deep in debt. It may be more difficult, but smart debt management can help pave the way for you to own a home. Here are some practical and achievable tips on managing debt and becoming a homeowner.
One term you’re likely to see often when house-hunting is DTI or debt-to-income ratio. Lenders want to know what percentage of your income goes to paying off the debt you already have. A high DTI suggests you’ve already tied up a good amount of your income and adding a mortgage could be too financially taxing for you.
Generally, lenders prefer to see a DTI ratio under 40% of your total gross income. So, for example, if you make $3,000 per month (typical median annual income for Millennials is around $35,000), your total debt payments should be less than $1,200. Some lenders may choose a lower DTI, like 35%, as their cap to offer a loan.
A few ways to reduce your DTI ratio are:
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The often-cited industry gold standard down payment is 20% to buy a home. Typically, having this level of down payment, you may get a more favorable interest rate and save on the mortgage insurance premium that is generally associated with loans that have less than 20% down payments. If you are already managing tens of thousands of dollars in other debt, 20% may not be achievable and the good news is that there are many mortgage options available with lower down payment requirements, especially for first-time homebuyers. Having stable employment and a strong credit score will also help you qualify for loans at better rates (another great reason to reduce some credit card debt before house hunting!).
Investing your time in pre-purchase homeownership counseling and taking a homebuyer education course is highly recommended before you begin your homeownership journey. You will learn about the loan options available, down payment options, programs, and what to expect as a homeowner. Many loan programs also require this education for first-time homebuyers. You’ll still work through a lender such as a mortgage bank or a non-profit community development financial institution, so it’s important to compare options, negotiate, and ask questions to find the best rates and terms. The better your credit, the more lenders you’re likely to find who will approve you (getting over 600 or so is a good goal to set).
Based on your income, credit history, and debt ratios, lenders may pre-qualify you for a certain maximum loan amount. Be careful. This maximum may be okay with the lender, but more importantly, this amount needs to fit into your overall operating budget. Generally, you should aim to keep housing costs below 35% of your income. That includes associated costs like utilities, taxes, insurance, and maintenance. Going over this figure could put you at a higher risk of being “house-poor,” tying up too much of your paycheck in your home.
Debt makes buying a home harder, but it’s far from impossible. If you’re managing your current debt comfortably, you may find lenders who will help you reach your homeownership dream. If you’re struggling with your debt, don’t give up, either. Work with a financial counselor to build a debt management plan so you can balance your obligations and your goals.
If you need help with credit or debt, or want to learn more about budgeting or personal finance, get started with free, confidential counseling and education right here at Credit.org.
