How Does Debt Impact Your Ability to Buy a House?

Your current debt is an important factor when choosing a home-buying budget that works for you and gets approved by a lender.  

Lenders evaluate your debt-to-income ratio and the types of debt you have to determine approval and a maximum home loan amount.   

Here’s everything you need to know about how debt affects your home-buying journey.   

What is debt-to-income ratio? 

Debt-to-income ratio is the calculation used by lenders to figure out how much income you bring in versus how much money you spend on debt payments each month. Lenders use your gross income, which refers to the amount of money you earn before taxes and any deductions come out. 

Then they add together your monthly debts, such as auto loans, student loans, and credit card bills. The lender also estimates your monthly mortgage payment based on the loan size you want.

Your mortgage payment estimate includes principal and interest, as well as estimates for homeowners’ insurance, property taxes, and anticipated private mortgage insurance. All those monthly payments are added up and divided by your gross income to get a percentage–and that’s your DTI.  

Let’s say you make $6,000 a month before your taxes and any deductions are taken out (like retirement contributions or healthcare premiums). Your total monthly debt payments (including a new mortgage) totals $2,500.

To find your DTI, you would divide your debt ($2,500) by your income ($6,000). That comes to 0.416%. Multiply that by 100 to come up with the DTI, which is 41.6%. 

For a mortgage, most lenders set a maximum DTI anywhere between 35% and 45%. Some FHA loans may allow for a DTI up to 50%. 

Different types of debt and how they impact your home purchase  

In addition to monthly debt payments impacting your DTI, some types of debt are treated differently when evaluating your mortgage application. Here’s what to know about each one.  

Medical debt 

Medical debt impacts millions of Americans; over 14 million people in the U.S. owe more than $1,000 in medical bills. Recent reforms, however, have changed how lenders can use medical debt in the approval process.  

• Paid, medical-related collection debts are now dropped from credit reports 
• Unpaid medical collection debt isn’t reported until one year (compared to six months previously) 
• Medical debts under $500 aren’t included on credit reports 

Student loan debt 

Student loan debt is treated differently depending on the type of mortgage you choose.  

For conventional loans, lenders may use 1% of your outstanding loan balance to calculate DTI – even if your student loan is currently deferred. FHA loans, on the other hand, use your actual monthly payment.  

Your student loan debt could be excluded from your DTI if you have less than 10 months of payments left or if you’re in deferment or forbearance and qualify for forgiveness afterwards. 

Credit card debt 

Lenders use your monthly minimum payment towards DTI. But because credit card debt is considered a form of revolving credit, it can lower your credit score more than an installment loan of the same amount. That’s because there’s no fixed payoff period and interest rates are typically variable.  

3 ways to lower your DTI before house hunting 

As you prepare to buy a home, consider your options for lowering your debt-to-income ratio. This will either improve your chances of getting approved for a large home loan amount or potentially qualify you for a lower mortgage rate. 

Make extra payments on high-interest debt 

The most straightforward way to lower your debt-to-income ratio is to simply pay down that debt more aggressively. Reevaluate your budget to identify spending areas to cut back on.  

Another option is to increase your income by working extra hours, asking for a raise, or taking on a side hustle.  

This likely won’t help increase the income counted in your DTI until you’ve earned that extra cash consistently for two years. But it does give you more room in your budget to pay down your debt. 

Consolidate credit card debt 

Another way to lower your DTI before buying a house is to pay off your credit card debt with a debt consolidation loan. Transferring revolving debt into an installment loan could increase your credit score and potentially save you money on interest payments. Plus, you’ll feel more confident buying a home knowing that you have a clear payoff timeline for that debt.  

However, opening any new type of credit right before applying for a mortgage can impact your chances of approval. Opening a new credit line and closing a previous account can cause a short-term drop in your credit score. 

Evaluate your student loan repayment plan 

The average student loan payment is $503, which can take up a large percentage of an individual’s DTI. If you have federal student loans, one option is to apply for an income-driven repayment plan.

There are a few different options to choose from, but they all adjust your monthly payment based on your income and your family size.  

Buying a house with confidence 

While calculating your debt-to-income ratio may seem like a hurdle to buying a house, it’s a helpful safety measure that ensures you don’t borrow more than you can afford.  

Look at your DTI as early as possible in the home-buying process. That way, you can either get a realistic sense of your budget or have time to make adjustments before you start house hunting. 

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