All debts are not created equal. Lenders look at each type differently and with a different level of risk. Understanding the types of debts and how they affect your mortgage approval can help you prepare for your mortgage application.
What is a Debt Ratio?
First, let’s talk about the importance of your debt ratio. Despite the type of debt that you have, a lender will calculate your debt ratio. This is the comparison of your gross monthly income to your monthly debts. Lenders only include debts that report on your credit report in your debt ratio, with the exception of a 401K loan if you use that for your down payment.
Each loan program has a specific maximum debt ratio that you can have in order to qualify for the loan program. The max DTIs are as follows:
- Conventional loans – 28% housing ratio and 36% housing ratio
- FHA loans – 31% housing ratio and 43% total debt ratio
- VA loans – 41% – 43% total debt ratio
- USDA loans – 29% housing ratio and 41% total debt ratio
It’s best to keep your debt ratios in line with these requirements if you want to get any of the above loan programs.
The Different Types of Debts
Now, lenders will dig deeper to see what types of debt you have. It’s not enough to say that your debt ratio falls within the guidelines. The lender needs to know where your money goes each month so that they can decide if you are a good risk. There are two main types of debts – secured and unsecured debt.
- Secured debt – A mortgage or car loan are the two most common examples of secured debt. These debts have collateral tied to them. If you don’t make your payments, the lender can come after the collateral (car or home) and take it from you.
- Unsecured debt – A credit card is the most common example of unsecured debt. The credit card company gives you a credit line based on your qualifications. They don’t have collateral to come after if you don’t pay your bills though.
Next we’ll go over the different types of secured and unsecured debts.
Housing debt is your mortgage. You can have a first mortgage or second mortgage. A first mortgage is what you use to purchase the home. This is usually your largest debt. Let’s say you use the FHA program to buy a home, this would be the first lien on your property.
If you also took equity out of your home with a home equity line of credit, that would be a second lien on the property. Second mortgages are also secured debt, they just come ‘second’ in line. If you default on your loans, the FHA lender would get first payout from the proceeds of the sale of the home and the HELOC lender would get what was left.
Lenders take housing debt very seriously. If you have housing debt already and aren’t paying it off with the sale of the home, you’d have to qualify for a loan with two housing loans, which can be tricky to do.
Installment Loan Debt
The most common installment loan debt is the car loan. Again, this would be a secured loan. The payment on the loan is predictable, as it is what it reports on the credit report. Your payment doesn’t typically change, so lenders can use it as it is when calculating your debt ratio and ability to repay the potential mortgage.
It’s possible to get an unsecured installment loan as well, though. Personal loans are the best example. If you need money for a personal expense or even to consolidate debt, you may apply for an unsecured personal loan. The interest rates on these loans are often higher because of the higher risk of default.
Credit Card Debt
Credit card debt is unsecured debt, as we spoke about above; it’s also the riskiest debt to have when applying for a mortgage. Credit card debt can vary, as can the monthly payments. Lenders look closely at how much credit card debt you have.
Typically, lenders want to see no more than 20% – 30% of your credit limit outstanding at the time of mortgage application. Of course, your payments must fit into your debt ratio in order for this to work. Obviously, no credit card debt is better than having any, but keeping it manageable can still allow you to secure an approval.
Student Loan Debt
Student loan debt is a tricky one when it comes to mortgage approval. It depends on where you stand with the debt. Many college graduates are able to get their student loan debt deferred. In other words, you don’t have to make payments on it just yet. Other graduates are able to get a payment arrangement that helps decrease their required payments while they work on increasing their income.
You’ll need to have solid proof of the amount of your student loan payments even if you don’t make payments right now. If you don’t have proof of the future payment from the loan servicer or Department of Education the lender may use 1% of the outstanding balance as your payment. This could greatly inflate your debt ratio, making it harder to secure mortgage approval.
Collections and Judgments
Collections and judgments are the worst type of debt you can have on your credit report. Unless the debts are of medical nature, you’ll typically have to pay the debts off either before you close on the loan or at the closing. This means showing that you have adequate assets to pay them off and proving that they are satisfied with a paid-in-full letter from the creditor.
Different debts affect your mortgage approval in different ways. Being honest with your lender and letting them know what you have on your plate can help you work through the process with ease. The least amount of debt you have going into the application, the better your chances of approval.