Are you renting your home and paying each month while gaining zero equity? Maybe you have a pile of debt that is stopping you from pursuing homeownership. From student loans to credit card debt, many Americans are in the same position, but it doesn’t mean you can’t buy a home.
Millennials represent the largest percentage of recent homebuyers, according to the National Association of Realtors 2015 Home Buyer and Seller Generational Trends study. The generation also has quite a bit of debt. Filene says in their Gen Y Personal Finances: A Crisis of Confidence and Capability report that two-thirds of millennials who are 23 to 35 years old have one source of long-term debt and one-third of them have more than one source.
How are millennials buying homes with large amounts of debt? Well, debt can actually help you get a mortgage, as backward as that sounds, if you have the right amount. Here’s what you need to know.
Manage your debt-to-income ratio
A large part of getting approved for a mortgage is having the right debt-to-income ratio. This is determined by adding up all of your monthly payments toward your debt and dividing it by the amount of monthly income you have. For example, if you earn $4,000 per month in gross income and have a car payment of $350, a student loan payment of $200 and minimum credit card payments of $150, your total debt without a mortgage is $700.
Monthly gross income: $4,000
Car payment: $350
Student loan payment: $200
Minimum credit card payment: $150
Debts per month without mortgage: $700
The maximum debt-to-income ratio for a mortgage and all other obligations is 43%, per the Ability-to-Repay Rule from the Consumer Finance Protection Bureau (CFPB). The CFPB found that when debt accounts for more than 43% of gross income, borrowers are much more likely to default.
Using the example above, let’s say you add in a mortgage payment of $1,000 per month, which is about what you would pay on a $150,000 30-year, fixed-rate mortgage at current interest rates (slightly below 4%), when you include taxes and home insurance. The $1,000 mortgage payment plus other debt obligations takes you to $1,700 in total debt payments per month. When you calculate the debt-to-income ratio, you get 42%, which will put you under the 43% maximum. In this scenario, you qualify for a mortgage.
Keep in mind you can also have too little debt when seeking a mortgage. If you don’t have any credit history, it shows you are inexperienced with borrowing, which makes you a higher risk.
What if your amount of debt is too high? Well, you can focus on paying it down over time, making more money, or you can look into other options such as debt consolidation, refinancing, credit building and applying with a cosigner.
Debt consolidation or refinancing
Debt consolidation is the process of taking out a new loan that will pay off all of your old debts so you’re left with one payment per month. This can help to get your monthly payment down and organize all of your debts into one convenient place. To consolidate, you can take out a personal loan or do a credit card balance transfer.
Refinancing is when you apply with a new lender that can offer you better rates and a lower monthly payment on an existing loan. You can refinance your car loan and student loans, for example.
Clean up your credit
Credit building also plays an important role. The better your credit, the lower the interest rate you will get. With a lower interest rate, your monthly payments will decrease, which means you’ll have a lower debt-to-income ratio. So check your credit report and see whether you have any negative marks to clean up. Also, be sure you are making all of your payments on time.
Learn more about improving your credit report.
Get a cosigner
If your debt-to-income ratio is too high and you can’t get it down or if your credit isn’t up to par, another option is to get a cosigner. Cosigners agree to pay the loan in case you default, and must provide their own proof of income and credit report, along with yours. Of course, this places great responsibility on the cosigner, so you will have to earn their trust that you will pay your mortgage on time each month. If you don’t, they will be responsible for paying the loan or they will face a negative mark on their credit report.
Opt for a low down payment loan
If you have debt, you probably will be concerned about the down payment for your mortgage loan. Conventional loans can require up to 20% down, which may be more than you are able to pay. However, other programs such as the FHA, VA, USDA and Conventional 97% loan to value ask for 0% to 3.5% down. Many people are familiar with the programs provided by the Federal government which include FHA, VA and USDA loans, however, the Conventional 97 program is newer and less known. It is a program created by Fannie Mae which aims to lower the barriers to home ownership by offering 97% loan-to-value, meaning only 3% is required for the down payment.
Learn more about how to finance a house with a low down payment.
Buy a home, even with debt
You don’t have to pay rent month after month while wishing your money was going toward a home of your own. Even if you are one of the 40 million Americans with student debt (Federal Student Aid Portfolio Summary), don’t let that hold you back because it is your total debt picture that matters. Check your credit report and calculate your debt-to-income ratio. If it needs a little work to stay under the 43% limit, consider debt consolidation, refinancing, building your credit or finding a cosigner. Then, choose a mortgage lender, apply and find the home you have been dreaming about.
Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.