Article Summary: If you are planning to buy a home in 2012 or beyond, you should consider reducing your credit card debt. There are two reasons for this, and they are both thoroughly explained in this article.
Did you know that carrying too much credit card debt can hurt your chances of getting a mortgage loan? It’s true. But it comes as a surprise to a lot of first-time home buyers. I know this, because I get a lot of their emails. They say things like this: “I knew my credit card debt was a problem for other reasons, but I never thought it would lead to my mortgage application being denied.”
Many home buyers learn this lesson too late. So I’m writing this article to teach you this important lesson now, before you get deep into the mortgage process. If you understand the connection between credit card debt and mortgage approval, you’ll be in a much better position when it comes time to apply for a loan.
How Credit Card Debt Affects Home Buyers
Why do home buyers need to be concerned with the amount of credit card debt they have? How does it even relate to the home-buying process at all? It has everything to do with the mortgage approval process. In fact, having too much debt can hurt you in two ways. It can lower your credit score, and it can also hurt your debt-to-income ratio. Both of these things will make it harder to qualify for a loan, especially in 2012. Lenders today are much more concerned with your total debt load, and they will turn you down cold if they feel you are carrying too much.
During the easy-credit days of the housing boom, this was basically a non-issue. Back then, lenders would hardly bat an eyelash at your debt ratios. But we have experienced a 180-degree turnaround since then. Today, the amount of debt you have can make or break your chances of getting approved for a home loan — all by itself.
Problems Associated With Excessive Credit Card Debt
There’s nothing wrong with carrying a small and manageable amount of credit card debt. It’s something that millions of Americans share in common. But when you have an excessive level of debt in relation to your income, it can hurt your chances of getting approved for a mortgage loan.
There are two primary reasons for this, and they are both referred to as “ratios”…
- A high credit-utilization ratio will lower your FICO credit score, which makes it harder to get a loan.
- When you carry too much debt relative to your income, you show that you can’t manage your finances properly. This is your debt-to-income ratio, or DTI, and it can raise a red flag with mortgage lenders.
Now let’s talk about each one of these problems in turn:
Your Credit-Utilization Ratio
I probably don’t need to tell you about the connection between credit scores and mortgage loans. Here’s the short version. When you apply for a home loan in 2012, the lender will review every aspect of your financial background. Your FICO credit score is a big part of this review process. If you have a high score, you’ll be more likely to get approved for the loan — and you’ll also get a better interest rate on the loan. But if your score is too low, you might get turned down altogether. Your score is basically a statistical indicator of risk. The lower the number, the more risk you bring to the table (from the lender’s perspective). And vice versa.
What does this have to do with credit card debt, you ask? Good question. If your card balances are extremely high, relative to your card limits, it will actually drag down your credit score. In fact, the “credit-utilization ratio” (as it’s known) is one of the top two factors that influence your score. So if you can reduce the amount of credit card debt you currently have, you will likely increase your FICO score at the same time. This will help you get approved for a mortgage loan, and it will also help you qualify for the lender’s best rates.
The utilization ratio is part of the formula that determines your FICO credit score. This ratio is a comparison between the amount of credit you have available (your limit) and the amount you are actually using (your balance). For example, if you have a credit card with a $5,000 limit, and your balance is $4,400, then you have a very high utilization ratio. You are nearly maxed out. This also shows that you rely too heavily on your credit cards.
You can see from the chart below that the amount you owe on your credit accounts drives 30% of your FICO credit score. This is the red slice of the pie chart. FICO is the one used by most mortgage lenders, by the way. So if you’re carrying too much debt in this department, it can really drag your score down.
Here’s the bottom line on utilization. Carrying too much credit card debt can hurt your credit score, which lowers your chances of being approved for a mortgage loan in 2012. There is a direct relationship between one thing and the other. There’s another ratio we need to talk about, and it too can affect your chances of loan approval. It’s called your DTI.
Your Debt-to-Income Ratio (DTI)
I’ve just given you some pretty good motivation for reducing your credit card debt before applying for a loan. Here’s another incentive for you. If your overall debt is too high in relation to your gross income, you will have problems getting approved for a mortgage loan in 2012. This is known as the debt-to-income ratio. It’s a comparison between the amount of money you pay toward your debts each month, and the amount of money you earn. And it’s another one of the key requirements for getting a loan.
This is similar to the ratio we talked about above, but it compares your overall debt to your income level. This is something mortgage lenders use to judge your financial stability. If you have a lot of debt already, relative to your income, you’ll probably have a hard time getting approved for a loan. A high percentage of people in this situation end up in foreclosure later on. Lenders know this, so they are reluctant to give mortgages to people with DTI ratios above a certain level.
This all theoretical so far. But what about the actual numbers? How much debt can you have when buying a house in 2012? This will vary, depending on the lender and the type of loan program you use. For instance, the criteria for government-backed mortgages are generally more lenient than the criteria for conventional loans. Suffice to say, if your total debt load (including your future mortgage payment) will use up more than 50% of your gross monthly income, you might have trouble qualifying for a mortgage.
[See also: FHA Loan Guidelines for 2012]
This is another good reason to reduce your credit card debt before trying to buy a home. If you’re carrying too much, it can drag down your credit score as well as your DTI ratio. And both of these things will make it harder to get approved for a mortgage. Call it a double whammy, if you like.
Where to Find Legitimate Help
There are plenty of companies out there that would gladly take your money, in exchange for their credit help services. But many of them are scams. They require upfront payments from their customers, and then they fail to deliver on their bold promises. Do a search for “credit card help” on the FTC’s website, and you’ll see what I mean.
But there are also a handful of legitimate non-profit organizations that can help you create a debt-reduction plan. They obviously won’t pay your bills for you — that’s your responsibility. But they can help you set up a budget, a payment plan and more. Here are two organizations worth considering:
In addition to the organizations above, you might want to consider talking to a HUD-approved housing counselor. They can give you advice on home buying, credit issues and more. You can find a counselor in your area by visiting the HUD website.
Whatever you do, steer clear of the so-called “debt relief” companies with the bold promises. They just want your money. Stick to the non-profit organizations I’ve listed above.
Conclusion and Going Forward
Using a credit card can actually help you improve your credit score, which makes it easier to get a mortgage loan. This might sound counterintuitive, but it’s not. It all comes down to how you use the credit you are given. Consider the following two scenarios:
If you make occasional purchases with your card and pay the balance down each month, it creates a pattern of responsible usage. It shows lenders that you know how to use credit wisely, which is exactly what they want to see. Here’s what is says about this subject on the FICO website (the people who developed the most popular credit-scoring model):
Someone with no credit cards, for example, tends to be higher risk than someone who has managed credit cards responsibly.
The key word in this quote is “responsibly.” By keeping your balance low, relative to your limit, you can create a long pattern of responsible usage. This will boost your score and make it easier to get mortgage loans and other financing.
On the other hand, if you rack up a lot of credit card debt, you are creating a pattern of over-reliance and irresponsible usage. This can lower your FICO score. You are also increasing your total debt, relative to your income. Both of these things will make it harder to get a mortgage loan — especially in the post-recession economy where we find ourselves today.